Path: bloom-picayune.mit.edu!snorkelwacker.mit.edu!news.media.mit.edu!americast.com!usa-post Newsgroups: usa-today.bonus From: usa-post@AmeriCast.Com Organization: American Cybercasting Approved: usa-post@AmeriCast.com Subject: bonus Wed, Mar 18 1992 Date: Wed, 18 Mar 92 05:44:27 EST Message-ID: 03-18 0000 BONUS: Some say bond market overreacts USA TODAY Update March 18, 1992 Source: USA TODAY:Gannett National Information Network As signs of economic recovery start popping up across the USA, a terrifying specter is haunting Wall Street. The specter is inflation, which bond investors believe is lurking in the shadow of a reviving economy. Inflation is the Big Foot of the financial world. Mere talk of this bogyman terrifies the bond market, sending long-term interest rates higher as investors demand higher yields to compensate for the inflation they expect. Maybe the bond market should chill out and look around. The inflation beast just isn't real, economists say. DOES ECONOMIC RECOVERY MEAN INFLATION? "Some people incorrectly assume that economic recovery means inflation," says Donald Ratajczak, director of economic forecasting at Georgia State University. "There's no evidence that's what occurs." In fact, after three of the past five recessions, inflation fell sharply the first year of recovery. WHAT EVIDENCE IS THERE THAT INFLATION FELL? After the 1982 recession, the economy entered the longest peacetime expansion in U.S. economic history - November 1982 through June 1990. By the mid-'80s, the economy was booming, yet even that couldn't get inflation going. From 1982 through 1986, the consumer price index rose 3.8%, 3.8%, 3.9%, 3.8% and - aided by an oil-price collapse - 1.1%. "Inflation was put on the shelf in 1982," says Ratajczak. WHY ARE BOND TRADERS NOT CONVINCED? Since mid-January, yields on 30-year government bonds have jumped from 7.39% to more than 8%. Rates began to rise as economic reports started to show signs of recovery. The government reported gains in retail sales, construction spending and new-home sales for February. Last week, the University of Michigan reported that its closely watched consumer-confidence index jumped to 74.6 early this month from 68.8 last month. Tuesday, there was more evidence of recovery. HOW BIG IS THE THREAT OF INFLATION? The Labor Department said consumer prices rose only 0.3% in February from January - a meager 3.5% inflation rate if prices continued at that pace for 12 months. Last year, inflation was 3.1%. So the figures show there is some inflation. But economists say bond traders have blown the threat way out of proportion. WHAT DO ECONOMISTS HAVE TO SAY? Economists argue that the inflation monster won't come roaring back the next few years because: The Federal Reserve Board is a committed inflation fighter. The 1981-82 recession was largely the result of the Fed, led by then-chairman Paul Volcker, pushing interest rates higher to wring inflation out of an overheated economy. At his 1987 confirmation hearing to succeed Volcker, Fed Chairman Alan Greenspan said it is "absolutely essential (that the Fed's) central focus be on restraining inflation." WHAT CAN THE FED DO? To keep prices from spiraling out of control, the Fed can directly raise or lower a key short-term interest rate and influence other rates by expanding or constricting the U.S. money supply. HOW WILL THE CLIMATE EASE BUSINESS FEARS? Few workers will be pounding the boss' desk for higher pay when there are 9.2 million people unemployed and ready to grab any job that becomes available. Last month, the unemployment rate was 7.3%. Even with a budding economic recovery, the jobless rate isn't expected to improve much this year. Because wages and benefits are most companies' biggest cost, low - or no - pay raises mean businesses will be under less pressure to raise prices. WHAT ELSE WILL HOLD PRICES? Foreign competition. "The list of products affected by foreign competition keeps growing," says Murray Weidenbaum, an economist at Washington University in St. Louis and a former chairman of president Reagan's Council of Economic Advisers. "It's not just cars now. It's most manufactured goods, and anything related to technology." ARE COMPANIES READY FOR HIGHER DEMAND? As usual, companies slashed costs and became more efficient during the recession. Now, they're poised to meet the higher demand a recovery will bring for their goods and services without resorting automatically to higher prices. Raw-material prices have risen only 3.9% a year since 1986. And the past year, many commodities prices have been flat or fallen. Because of plentiful supplies and slack demand, no one sees prices of key commodities like aluminum, copper and steel rising more than modestly the next few years. HOW DOES THE FALL COMMUNISM HELP MATTERS? The fall of communism and the breakup of the Soviet Union mean the USA will be able to cut billions from the defense budget. That will help keep inflation under control, since massive government spending on military build-ups has fueled inflation in the past. "I remember the inflationary impact of the Vietnam War build-up," says Weidenbaum. "A lot of older investors think that is what started the post-World War II inflation" in 1966. WHAT ARE THE WILD CARDS ON THE INFLATION OUTLOOK? Food and energy prices. Since World War II, two major inflation flare-ups can be traced to crude oil price hikes. The Arab oil embargo in 1973 forced crude oil prices from $2.90 a barrel to $11.65 a barrel in four months. Then in 1979, threat of war in the Middle East pushed oil prices from $13 a barrel to $34 a barrel. But even when food and oil prices do flare, the spikes usually are short-lived and are offset by good CPI reports when food and oil prices fall back, which they always seem to do. WHAT CAN BOND INVESTORS POSSIBLY BE WORRIED ABOUT? Some economists say it's as simple as bond traders still reliving the 1970s. Many older Americans had their investment habits shaped by the Great Depression. Germans are still haunted by the hyperinflation their country experienced in the 1920s. Likewise, most bond-trading desks on Wall Street have senior traders who were starting their careers during the 1970s, a decade that produced annual CPI increases of 8.7%, 9%, 12.3% and 13.3%. Despite an entire decade of low inflation in the '80s, some traders still fear we'll one day revert to double-digit inflation. SO WHY AREN'T 30-YEAR YIELDING 5% OR 6% INSTEAD OF 8%? "Bond traders don't like to make a 30-year bet on an 18-month economic forecast," says Stuart Hoffman, chief economist at PNC Financial in Pittsburgh. "That leaves them with 28 1:2 years to worry about what inflation will do." Bonus Editor: Michele Coleman. (1-919-855-3491) Making copies of USA TODAY Update (Copyright, 1992) for further distribution violates federal law. This article is copyright 1992 Gannett News Service. Redistribution to other sites is not permitted except by arrangement with American Cybercasting Corporation. For more information, send-email to usa@AmeriCast.COM