Inflation Forces May Be Deflating

By Michael Englund
A quicker-than-expected slowing in price pressures is looking more likely and will change the dynamic between the Fed and the markets
In May, investors were hit with some unwelcome news on inflation, courtesy of larger-than-expected increases in each of the closely watched indexes for consumer prices (CPI), producer prices (PPI), and trade prices.
However, early indicators are suggesting a lull in those reports for June (each is scheduled for release the week of July 12). And we at Action Economics expect this weakness to extend through July as well. The reports will provide a welcome relief from inflation worries for the bond markets — and present new challenges for the Federal Reserve.

With this new round of statistics, the markets may indeed begin to question whether even “measured” quarter-point rate hikes at the four remaining Federal Reserve policymaking meetings this year are necessary.
THE NEXT MOVE. It’s our assumption that the Fed will want to adhere to a steady tightening trajectory now that it has commenced the rate-raising cycle and won’t likely pause until the Fed funds rate gets to a level that some in the markets will plausibly see as “neutral.” But the ball will now be firmly in Chairman Greenspan’s court, as he’ll be able to credibly argue for either a lessened or heightened pace of tightening, if he so chooses.
It’s an interesting dilemma for the central bank given our expectation of impressive weakness in the U.S. inflation reports for both June and July. First on tap will be the U.S. trade price indexes for June, to be released on July 14, which should reveal a flat figure for export prices and a 0.3% drop for import prices. The July data for trade prices should be equally soft. On July 15, comes the June PPI report, which should reveal a flat overall figure and a modest 0.2% “core” price gain, which excludes food and energy prices. Immediate weakness should be seen in the energy price component, though we expect more softness here in July as well.
ENERGY SOARS. On July 16, the June CPI report comes out, and here we expect a modest 0.2% gain in both the overall and core measures. The headline inflation reports for both June and July should primarily benefit from a reversal in both food and energy prices following powerful gains through the first five months of 2004. They should also reflect diminished wage pressure in the pipeline and renewed stability in the dollar’s value through 2004, following big declines in 2002 and 2003.
Recent energy price relief is less likely to be evident in the June CPI report, implying that more “downside correction” could be coming in the July data. We project a sluggish 0.1% overall gain. As for food, the correction can be seen in the GSCI (Goldman Sachs Commodity Index) agricultural price index, which fell 5% in June on top of a 4% drop in May. The Agriculture’s Dept.’s monthly Ag-Price index was flat in June, following a 3.2% gain in May, which is less impressive on the surface. But this index is poised for a sizable downside correction in July and August that should reverse the hefty 15% surge seen since February. Both measures suggest that the peak in food price pressure has passed.
The same can be said for energy prices. The benchmark West Texas Intermediate grade of crude oil fell in June by 6%, following a steady string of monthly gains since September of last year that have averaged 3% per month. We expect a common seasonal energy price pattern to be evident this year, with the annual peak at midyear followed by declines into the winter months.
Gasoline pump prices have been less quick to drop, but we expect a string of declines that may be evident in the June PPI data, and that will be even more apparent in both the CPI and PPI data for July.
THE DOLLAR HOVERS. The recent employment report also provided some welcome relief on the wage front. The persistent 0.2% to 0.3% gains through the first five months were beginning to suggest a significant cyclical turn in wages. But with the small 0.1% gain in June average hourly earnings, and the ensuing drop in year-over-year wage growth (on a nonseasonally adjusted basis) to only 1.7%, it now appears that only limited wage inflation is in the system. Wall Street will view this as less of a problem now that job growth has cooled.
Finally, the dollar’s value vs. other major currencies is still hovering around its yearend level, thanks to a rebound through May that has only partly reversed course thus far this year. This implies that the lagging impact of a falling dollar through 2002 and 2003 on current U.S. trade prices is likely diminishing — at least until a significant dollar downtrend resumes. This pause in “imported” inflation pressure, so evident in the May trade price report, will lessen the pressure on domestic inflation gauges.
In total, the next big story for U.S. inflation will be the lack of it, and this should be more apparent as the reports begin to hit financial markets the next few weeks. The Fed may keep on raising rates gradually the rest of the year, though the markets will no longer be pressing it to do so.
Source: Business Week