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Coming Soon to an Economy Near You: Inflation

July 07, 1996|TOM PETRUNO

Like the mammoth alien spacecrafts casting their shadows over the world's cities in the current movie blockbuster "Independence Day," so the shadow of rising inflation has slowly crept over U.S. financial markets this year.

With Friday's stunning June employment report showing yet another surge in new jobs--and a record 0.8% rise in average hourly wages during the month--Wall Street may have suspended the last bit of disbelief over the economy's resilience and what that may mean for inflation in the near future.

Granted, there weren't too many players in the markets Friday, given the holiday weekend. But those present were clear about their outlook for inflation and interest rates now, sending the benchmark 30-year Treasury bond yield rocketing from 6.93% to 7.19% and the Dow Jones industrial average down 114.88 points to 5,588.14, the lowest since mid-May.

If this all seems like deja vu, it should. The monthly job reports have repeatedly sent bond yields surging this year, and the February report, released March 8, was responsible for a 171-point plunge in the Dow that day.

But each time that the employment data suggested a healthier economy and growing inflationary pressures, many Wall Street pros scoffed, contending that the numbers were fluky. "Wait till next month," they'd say.

Likewise, the government's monthly consumer price index reports have shown that, by that measure, the U.S. inflation rate so far this year is running at an annualized rate of 4.1%, well above the 2.5% rate of 1995.

Skeptics have argued that the CPI has been skewed by temporary increases in gasoline and food prices and that the "core" rate of inflation remains tame.

But that's like saying there is no increase in inflation just so long as you don't eat or drive. Know anybody who qualifies for those demographic groups?

There have been other consistent arguments against a sustained upturn in wage and price inflation as well. People don't feel that their jobs are secure, so they have no bargaining power with employers. Companies can't pass along price increases because the world economy is too competitive. Productivity gains will allow businesses to swallow higher costs without boosting prices.

All true, to an extent. And still, the numbers this year show that somewhere out there in the giant U.S. economy more people are getting bigger raises, and the costs of some goods and services are rising faster than in 1995.

David Dreman, veteran money manager at Kemper/Dreman Asset Management in New York, says those investors who have assumed that inflation had simply disappeared from the financial landscape were harboring "ludicrous" expectations. "To have an economy with full employment, rising [gross domestic product] and all these good things, but no inflation--well, it ain't never happened," he says.

So with Friday's June employment data, it seems clear that more investors now will have to confront two of their deepest fears: That the days of super-low inflation are over, at least for the time being, and that the Federal Reserve Board has absolutely no choice but to begin tightening credit again to slow the economy and thus attach an anchor to the inflation trend.

Let's be very clear on one point: Nobody is talking about a return to the 13% annualized inflation rate of the late-1970s. In fact, nobody's even talking about half that rate.

But U.S. consumer price inflation has been subdued for so long--under 3% annualized each year since 1992, and declining almost continually since 1980--that the thought of even a 4% sustained annual rise in prices is potentially shocking to financial markets.

Similarly, annual average hourly wage inflation plunged from a 4.5% rate in mid-1989 to nearly 2% in late 1993, and has been only creeping higher since, before breaking decisively above 3% this year. The June employment report pegged wage growth at a 3.4% annual rate, highest since 1991.

For Wall Street, the idea of higher inflation really is like an alien invader come to town: Investors aren't quite sure how to react (who remembers the 1970s?) but they know enough to realize that this alien brings some kind of new risk to the situation.

Why do financial markets hate rising price inflation? Because it cheapens the value of money and financial assets. Thus, bond yields rise because investors want to be guaranteed a decent after-inflation, or "real" yield on their money. And stock prices aren't worth as much because investors question the true value of future earnings and dividends, if higher inflation is going to erode them.

Then there is the fear of the vicious cycle come again: If companies and individuals adopt an inflation mentality, the former may feel emboldened to pass through more price increases, and the latter may feel emboldened to demand ever-higher wages. The result can be an inflation spiral that becomes extremely difficult to halt.

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