Inflation Agitation

If the past week’s news cycle did not rattle investors, what will? Oh sure, on Thursday when it seemed like the world was spinning out of control, the CBOE Volatility Index (VIX), which helps gauge investor fear, surged 32 percent, its biggest jump in more than a year. Then on Friday, it fell 17 percent to 12.06, far below historical norms of around 20. Evidently, geopolitical events are not sufficient to cause more than a one day stock sell-off and flight to quality, most of which was reversed on Friday. So what would it take? Maybe run of the mill inflation, which has been almost absent for the past six years, would spook investors.

Headline inflation (CPI), which includes everything you care about, is up about two percent year over year. I know what you’re thinking: Why would the central bank exclude the stuff that impacts my daily life? Surely when I am spending more on food and gas, I have less money to spend elsewhere in the economy. (A recent Gallup poll found that 1/3 of Americans said higher prices are impinging on their ability to spend on travel, dining out and leisure activities.) But the Fed is not tasked with addressing short-term price increases, like those at the pumps, or even for agricultural items like beef, pork or chocolate -- the central bank can’t be at the mercy of the weather or events in the Middle East.

That’s why during the recovery, when prices have increased sporadically, the Fed downplayed the idea of broad-based inflation, calling the higher readings transitory (like when gas spiked due to the Arab Spring). More recently after the Fed’s June policy meeting, Chair Janet Yellen said that while “Recent readings on, for example, the CPI index have been a bit on the high side,” the data are “noisy.” Translation: Stop worrying about inflation—we have it under control.

The Fed is looking for a gradual increase of core inflation, which excludes food and energy, to a pace of two percent annually. Over the past six years, core inflation as measured by the CPI or by the Fed’s preferred metric, the Commerce Department’s personal consumption expenditures price index (PCE), has remained below that level. But over the past three months, core prices have started to accelerate across a variety of categories, including shelter, airfares, clothing and medical care.

It’s not so far-fetched to see how as the economic recovery accelerates, a chain of events is likely to spur price increases. Here’s what could happen: as the labor market improves, there is likely to be an increase in wages. As people earn more money, they may be willing to spend more. An uptick in spending could be the opening that retailers have been waiting for since the recession and allow them to finally increase prices for all sorts of stuff.

While it is unlikely that any of this would create runaway inflation, despite what some inflation hawks (including the usually wrong CNBC editor Rick Santelli) have been arguing for years. Remember we’re talking about what could spook investors, who are hyper-focused on when the Fed will begin to raise interest rates. It is widely believed that the central bank will begin to nudge up rates at the beginning to the middle of next year. But if prices rise faster than expected, it may prompt the Fed to hike rates sooner and more aggressively than widely expected. If that were to occur, stock investors might take a time out from the bull market and wait to see how things shake out.

MARKETS:

• DJIA: 17,100, up 0.9% on week, up 3.1% YTD
• S&P 500: 1978, up 0.5% on week, up 7% YTD
• NASDAQ: 4,432, up 0.4% on week, up 6.1% YTD
• 10-Year Treasury yield: 2.48% (from 2.52% a week ago)
• August Crude Oil: $103.13, up 2.3% on week
• August Gold: $1309.40, down 2% on week
• AAA Nat'l average price for gallon of regular Gas: $3.58 (from $3.67 a year ago)

THE WEEK AHEAD: The SEC is poised to impose new requirements on the $2.6 trillion dollar money-market mutual fund industry, when it votes on whether the riskiest money-market funds will have to let their share prices fluctuate; and charge investors withdrawal fees during times of stress. The government was forced to provide a backstop to money market funds during the 2008 financial crisis.

Mon 7/21:

Haliburton, Hasbro, Texas Instruments, Netflix

8:30 Chicago FedNational Activity Index

Tues 7/22:

Altria, Dupont, Kimberly Clark, McDonald’s, Apple, Microsoft, Coca-Cola, Verizon

8:30 Consumer Price Index

10:00 Existing Home Sales

Weds 7/23:

AT&T, Boeing, Facebook, Pepsi

SEC vote on Money Market funds

Thurs 7/24:

Ford, GM, Hershey, Starbux, Visa, 3M, Amazon, Caterpillar

8:30 Weekly Jobless Claims

10:00 New Home Sales

Fri 7/25:

Xerox

8:30 Durable Goods