Inflation risks continue despite slowing economic growth

William Hester, CFA
All rights reserved and actively enforced.
July 2004

It's becoming clear from a host of market prices that investors and traders expect economic growth to slow. The S&P 500 sits two percent below its Feb 11 high and has traded in a tight range for five months. The slope of the yield curve, which signals bond traders' forecast for growth, has dropped by a full percent in two months.

But even as investors assume slower economic growth their expectations for changes in the Fed Funds target rate have gone mostly unchanged. Can both forecasts be right?

The markets have good reason to assume slower economic growth. June economic data was weak on several fronts. Job growth was surprisingly tepid and industrial production actually contracted.

Leading indicators tell a similar story. The Economic Cycle Research Institute, a forecasting group, publishes the Weekly Leading Index which tracks such forward-looking indicators as jobless claims, mortgage applications, and credit spreads. The WLI has slowed dramatically over the last ten weeks, forecasting the end of above trend economic growth.

The Weekly Leading Index "is pointing to deceleration very clearly," said one of the group's economists this month.

It's an index worth watching because it forecasted the last two recessions in real time. It predicted the most recent recession in March of 2001, long before the consensus and other indicators began to call a slowdown.

Bridgewater Associates ( www.bridgewaterassociates.com ) has it's own leading index called the Market Based Growth Index. This index, which tracks a series of forward looking markets, has made its first pronounced downward move in about a year and a half.

Bridgewater analysts told their clients recently that "markets have been very good at staying ahead of the next move in the economy with a reasonably high level of accuracy. The markets discounted the big pickup in growth over the past year, but recently their enthusiasm has waned to an implied expectation of a more normal, moderate rate of growth."

These two indicators contrast with the more popular index of Leading Economic Indicators released by the Conference Board. Though the year over year rate of the LEI fell in June to 3.8 to 4.4, it's only two months off its high. Some economists, though, underweight the LEI because it missed forecasting both of the last recessions.

Interestingly, even with this number of financial and leading indicators signaling a moderation in economic growth, traders haven't dramatically changed their expectations for the path of Fed Funds rate changes over the next year.

Eurodollar futures contracts imply that the Fed Funds rate will be 3 percent by next summer. (Eurodollar contracts settle on the London interbank offering rate, or Libor, and have historically traded at about 25 basis points above the Fed's overnight rate.)

That's down from last month's forecast of 3.25 percent, but still implies a busy set of meetings for FOMC members. If each move is a quarter point, then the Fed would need to increase rates at every meeting over the next year but one.

Transitory Inflation Meets Slowing Economic Growth

One explanation why the Fed Funds target remains high is that Fed Funds have been held at an emergency level of 1 percent for a longer time than needed. This view argues that as long as economic growth doesn't drop precipitously, the Fed will raise interest rates until it achieves a more neutral rate. That's a rate that would align aggregate demand with growth in economic output, at a level that doesn't increase the rate of inflation.

The Fed Funds rate has traded at an average of 215 basis points above core inflation since 1970. With current core inflation of 1.9 percent, that would imply a target rate of about 4 percent.

Another explanation is that even if trend growth slows, interest rates will need to rise to fight "transitory inflation" - the Fed's newest buzz phrase.

Rising inflation has been priced into markets. The spread between the 10-year nominal bond and the 10-year Treasury Inflation Protected bond - the markets estimate of annual inflation over the period - is about 250 basis points, up 50 basis points from a year ago. This spread is also above the 2.3 percent that the yearly change in inflation has averaged this year.

Watching the FIG

Other leading indicators agree that higher inflation may be on its way. Another of ECRI's indexes - the Future Inflation Gauge - has been in an upswing since December. The FIG index attempts to forecast changes in the cyclical direction of inflation by tracking such things as materials prices, import prices, and delivery times (ECRI's Weekly Leading Index and Future Inflation Gauge are available on its website at www.businesscycle.com ).

The FIG's record on forecasting inflation has been mixed. It's been better at leading the Fed Funds target rate. The FIG rose strongly during the second half of 1993, forecasting the steep slope of interest rate increases in 1994. In 1999 it began rising before the Fed kicked off a series of rate increases that year. The index dropped in 2000 before the Fed began to cut rates.

It's safe to assume that Greenspan and the index move closely together because the FIG measures many of the same changes in price levels that Greenspan watches. In fact, Greenspan has mentioned the FIG in congressional testimony, and one his biographers has called it one of his favorite indicators.

Even so, the level of the FIG is up only 5 percent from the start of the year. That's a third of the rise prior to when the Fed began aggressively raising overnight rates in 1999.

FOMC members are already uncomfortable with the level of rising prices. Last week, Robert McTeer, President of the Federal Reserve Bank of Dallas, said inflation in the U.S. is already "higher than it should be." He added that it was too soon to tell if recent price increases are permanent.

In the months ahead, watch the FIG along with other indicators of inflation. The extent to which the Fed will need to raise interest rates - especially if economic growth moderates - will be determined by how persistent inflation threatens to be.

---

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic Total Return Fund, the Hussman Strategic International Fund, and the Hussman Strategic Dividend Value Fund, as well as Fund reports and other information, are available by clicking "The Funds" menu button from any page of this website.

Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).