New Surge in CORE Inflation!

Blazing Saddles was the top-grossing movie … All In The Family with Archie Bunker was the top-rated TV show … and Richard Nixon was battling an inflation that was, in some ways, very similar to today’s.

I’m Tony Sagami, and I’m talking about 1974.

Alas, I was a senior in high school then with a full head of hair and a flat stomach. So you don’t have to tell me how much has changed since then.

What’s most striking, however, is the similarities I see between then and now:

Similarity #1. The raging inflation.

The Labor Department has just reported that inflation at the wholesale level the Producer Price Index or PPI jumped by 1.9% in September. If that pace were to continue for a year, you’d be looking at 22% inflation.

Worse, the cost of intermediate goods products that are partially finished such as lumber and steel rose 2.5 percent. The last time this happened? You guessed it 1974.

Similarity #2. The self-delusion of our trusted leaders.

Back in the early 1970s, Nixon and his advisers deluded themselves into believing that government-mandated wage-and-price controls could stop inflation.

They didn’t pay much attention to chronic, supply-and-demand imbalances that were pushing prices up. They didn’t even listen to economists who told them, point blank, that government controls would only make the imbalances worse. Sure enough, inflation surged from “very manageable low levels” to double digits in 1974.

Now, fast forward to October 19, 2005.

Why You Shouldn’t Fall for The
“Don’t-Eat-Don’t-Drive” Trick

Today’s delusion is different. But it serves the same function.

Much like Nixon’s self-delusion of the 1970s, it gives our leaders a gimmick to help them ignore reality and make believe they’re actually doing something useful.

Their favorite trick: They keep telling you to focus your mind on the “core inflation rate,” excluding food and energy. If you do, they insist, the inflation magically disappears.

So what they’re saying is: “Don’t eat. Don’t drive. Instead of fast food, just fast. Instead of using gas, walk to the store or ride your bike.”

Sometimes I wonder: Are they on drugs? And are the drugs also one of those few, remaining items in the “well-contained” inflation category? The former is not likely; the latter, even less likely.

But let’s humor them for a moment and accept their theory that gas and food don’t matter. Let’s assume, for argument’s sake, that the only thing worthy of our attention is the so-called “core inflation.”

Well, I have a surprise for them:

Up until yesterday, they could have still made the argument that the core inflation rate is low. But yesterday, with the release of the producer price numbers, that argument was swept away. Like leaves on the sidewalk.

Here are the facts:

Fact #1. Inflation is a dynamic process that flows from one stage in the pipeline to the next …

1. A farmer harvests his cotton. That’s phase one raw materials.

2. The mill weaves it into fabric, the “intermediate goods” phase.

3. The wholesaler buys the garment, the “finished goods” phase.

4. The consumer buys it at the retail store the consumer phase.

On Friday, the government reported strictly the final phase (consumer prices), and it showed that the core inflation in September, excluding energy and food, was still tame.

But yesterday, they reported on phases 1, 2 and 3. And as I’ll show you now, the numbers demonstrate that key phases of core inflation in September were literally steaming.

Fact #2. Raw materials surged 10.2% in September, or at an annualized pace of over 122%! Was a lot of that due to the surge in energy? Of course. But lo and behold, even excluding food and energy, the core items still surged by 5.3% over 60% inflation if it kept going at that pace for a year!

Fact #3. Intermediate goods rose 2.5%. And, even excluding food and energy, the core intermediate items jumped 1.2%, the worst in 31 years. The primary drivers: Lumber, plywood, chemicals, and industrial metals.

Fact #4. This core price inflation is now moving through the pipeline on to the next phase. Almost inevitably, it will soon show up in consumer prices.

Bottom line: The “don’t-eat-don’t-drive” trick is dead.

And besides, I believe that those numbers even as jumbo as they are significantly understate the true rate of inflation.

I say that because the government number crunchers somehow figured that the cost of housing which accounts for nearly half of the inflation calculation dropped by 2.5% in September. If not for that accounting hanky-panky, the inflation numbers would be out of this world.

Hurricane Wilma is not going to hit the Gulf of Mexico oil rigs and pipelines. Sadly, this time of the year, it’s Florida’s west coast that’s most likely to get the brunt of the storm.

Meanwhile, what’s also possible is a continuing correction in oil and oil stocks. That’s why Martin told you to consider lightening up on energy stocks. And that’s also why Larry even suggested you look into some cheap insurance against a further energy stock decline such as an XLE put option.

Looking beyond the correction, though, the bitter winter is about to kick in. That means new pressure for higher fuel costs.

Plus, it means the double-whammy of high gasoline and high heating costs will crush the budgets of millions of Americans.

How Will Alan Greenspan
and His Fed Buddies React
to All These New, Highly
Inflammatory Inflation Numbers?

I can tell you how.

Even though they raised interest rates for the 11th time last month, they have no choice but to keep raising interest rates in November and December. If they don’t, they run the risk of allowing inflation to take off like a rocket and fly out of control.

And don’t be surprised in the least if the Fed abandons its quarter-point-baby-step policy and starts to raise rates more aggressively, by a half point at a time.

Martin has recently quoted various Fed bank presidents clear hints that they are getting geared up for bigger action. But here’s one that really hits home hard:

“To keep cyclical price pressures and any transitory spike in energy prices from permanently disrupting the price environment, the Fed will have to continue shifting monetary policy from its current somewhat accommodative stance to a more neutral one.”

Anthony Santomero, President,
Philadelphia Federal Reserve Bank

My interpretation: With inflation surging, a meager quarter-point hike would leave the Fed policy exactly where it was in the “accommodative” zone!

So in order to shift into a “more neutral” zone, the Fed must raise rates by one half point when it meets 13 days from today.

Would this be a shock to the markets? Absolutely!

Would it be unusual? Absolutely not!

In the past, it was common for the Fed to jack up interest rates by a half point at a time.

• In the 1970s and early 1980s, the Fed raised the Fed Funds rate by 10 full percentage points. This time around, although the Fed has raised interest rates 11 times, all they’ve achieved is a total rate increase of 2.75 points.

• Last time, the Fed funds rate peaked at 20%. Now, it’s still at 3.75%. Even if inflation is only half as bad, that implies a heck of a lot more room on the upside for interest rates.

Loser #1: Adjustable-rate borrowers. The impact on mortgage rates is clear: Last week, Freddie Mac reported that the rate on 30-year, fixed-rate home mortgages just topped that very important 6% barrier, reaching 6.03%.

And they’re not stopping there.

Freddie Mac’s chief economist, Frank Northaft, puts it this way: “The specter of rising energy costs will translate into higher long-term mortgage rates in the coming months … [and] reach 6.4% by 2006.”

Bottom line: Many homeowners are going to see substantial increases in their monthly payments.

Loser #2. Bondholders that become bag holders. “Never a lender be” will take on new meaning when bond and bond fund investors see the value of their investments shrink.

The price of 30-year Treasury bonds has fallen as its yield has increased from 4.26% on August 31 to 4.71% today. That price decline (and yield rise) has already hurt bond funds.

The Rydex Government Bond fund (RYGBX) is down 7.7% since August 31. The American Century 2025 fund (BTTRX) is down the same amount. Other bond funds may be down somewhat less. But overall, if we’re right about rising interest rates, this is just the beginning.

Loser #3: Corporate America and stock market investors. People forget how basic of a building block petroleum is in our modern world. Potlach’s latest explanation of their earnings shortfall is typical:

“The shortfall is largely attributable to the high cost of energy…these costs, which are approximately $10 million higher than third quarter 2004, are impacting almost every aspect of the company’s operation from natural gas used at its manufacturing facilities to in-bound and out-bound transportation surcharges.”

Alcoa’s refrain tells a similar story:

“This quarter, we are squeezed between a weaker upstream pricing environment and significantly higher energy and input costs. We continue to face challenges from escalating costs in energy and raw materials.”

Ditto for CONMED:

“CONMED continues to experience significant rising raw material pricing on petroleum based plastics and increased distribution costs. This has caused the profit margin to decline on many of our products.”

You may wonder why I quote so many company executives.

Simple: Because theyre not ones trying to play make-the-inflation-vanish tricks. Theyre on the firing line. And they see the big inflation bulge rolling through each phase of production.

I hope you do too so you can avoid being one of the inflation losers and join the inflation winners.

Best wishes,

Tony Sagami

2005 by Weiss Research, Inc. All rights reserved.
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