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ECONOMIC PERSPECTIVE
Prepared by
Merrill Lynch & Co.
Global Securities Research & Economics Group
The best news on Inflation is probably behind us for the next few months. In his February testimony, Greenspan warned that some of the beneficial factors working to hold inflation down while the economy was growing rapidly might be exhausting themselves. As it turned out, first half inflation dropped below 2% annualized from above 3% in the second half of 1997, appearing to contradict Greenspan's concern. Further, the data continued to improve following the Fed's 25- basis-point rate rise in March, leading many to think the rate hike was unwarranted. Now many analysts feel that the Fed will have to see credible evidence of rising inflation before raising rates in the face of continued robust demand.
While Greenspan has talked less “tough” in his most recent testimony, the best news on inflation is past and, on the margin, prices are likely to rise faster.
–Wage gains are likely to pick up due to the continuing tightening of the market, the rise in the minimum wage, and the high visibility of the recent UPS strike where, at least, the perception is that labor won gains that were previously unobtainable. It remains an open question as to whether businesses have enough pricing pressure to pass along increased wage costs.
–Airline fares and tobacco price increases as well as a let up in auto price incentives are likely to result in some upward price pressures.
–The energy and food price declines that mitigated inflation in the first half and allowed overall inflation to rise less than core inflation are not likely to be repeated in the second half. In particular, energy prices have started off the second half by rising moderately.
–Finally, the recent above-target rise in M2 growth suggests that economic growth will remain robust for the next few quarters, which could tighten the labor market further in the intermediate term (see our outlook for interest rates for a discussion of the Fed's and our concern with money growth).
Because inflation was rising at 3% in the second half of last year, the year-over-year rate of inflation may actually drop to as low as 2% over the next few months from the current year-over-year level of 2.2%. On the other hand if, as we expect, monthly readings are up 0.2% and 0.3% for the rest of the year, the annualized rate is likely to be near 3% in the second half, about twice the rate of the first half.
Longer run, we remain sanguine on inflation. The price discipline of globalization as well as improved productivity should continue for a number of years. Once the economy slows to a sub-normal pace, which should take place over time given the high real rates and stronger dollar, tight labor markets will likely unwind somewhat. Near term, however, the wolf, or at least a coyote, may be knocking, despite the Fed's apparent reluctance to announce its impending visit.
One area that we are not particularly concerned about is commodity inflation. While we indicated that the best news is behind us on declines in energy and food prices, that should not convey any concern that these prices will suddenly begin to exert upward pressure on consumer prices. First, the strength in the dollar will ensure that many basic goods and commodities can be imported at the same or even lower cost. Second, while there has been a lot of hype concerning El Nino (some of the concerns legitimate), huge plantings this year offset some of the tendency for disappointing yields, and will leave the U.S. with adequate if not burdensome stocks of grains and oilseeds. Finally, while energy prices have increased a bit over the past few months, spot crude oil prices have already given up much of the summer gains and the October contract is below $20 a barrel in the lower half of the $18.35 to $2240 spot range of the past 6 months. Finally, the recent fall in several key Asian currencies suggests that international competition for goods will remain intense, offsetting some of the upward price pressures in commodity prices faced by other countries whose currencies have not fared as well as the dollar and, if anything, cutting back their demand a bit for world traded commodities.
(Reprinted by permission. Copyright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
September 18, 1997David Horner
Merrill Lynch & Co.
Global Securities Research & Economics Group
North Tower, 21st Floor
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