Wednesday, January 18, 2006


CPI Report Shows More Deflation

The Labor Department reported lower prices. "U.S. consumer prices unexpectedly fell for a second month in December as energy prices declined, a government report showed. Excluding food and energy, prices rose no faster in 2005 than the year before. The 0.1 percent decline in the consumer price index follows a 0.6 percent decline in November, the first back-to-back declines in two years, the Labor Department said today."

"'Inflation pressures are fairly well-contained,' said Brian Bethune, an economist at a forecasting firm in Lexington, Massachusetts. 'This will reinforce the Fed's view that only a few more rate hikes are indicated for this monetary tightening cycle.'"

"The consumer price index is the government's broadest gauge of costs for goods and services. Almost 60 percent of the CPI covers prices consumers pay for services, ranging from medical visits to airline fares and movie tickets. Houston-based Continental Airlines Inc. said yesterday it had a fourth-quarter loss because of increased competition from low cost carriers and the inability to raise fares to cover higher fuel costs."

"'We continue to face significant challenges,' CEO Larry Kellner said in a statement. Crude oil 'still hovers at record-high prices.'"

"Wal-Mart Stores Inc.'s strategy of cutting prices hurt the Bentonville, Arkansas-based retailer's December results. The company said earlier this month that the smallest December sales gain in five years may erode fourth-quarter profit. A survey released last week by the National Federation of Independent Business showed fewer small business owners raised prices last month, and a declining number said they plan to charge more in coming months."

"U.S. producer prices excluding fuels and food rose less than forecast in December, a sign companies are having little success so far in passing along higher raw materials costs. Prices of goods imported into the U.S. unexpectedly fell for a second month in December, the first back-to-back decrease since 2004, suggesting overseas competition will limit domestic inflation."

Rates may rise for 2 reasons:

1. Inflation will increase when the Fed stops raising rates (and starts lowering them). The fact that the Fed is tightening monetary conditions and ostensibly keeping inflation in check has doubtless helped to keep the bond market complacent about inflation. When the Fed stops tightening, some of that complacency may disappear. When the Fed starts lowering rates, inflation expectations will almost certainly rise, and rates may rise along with them. I believe that the Fed is fairly close to completing its tightening cycle, so inflation expectations could increase within a couple months. When the Fed starts lowering is unclear for now, but the combination of a potentially slowing economy and financial market nervousness about a new Fed chair could induce the Fed to start cutting as early as the beginning of 2006.

2. The Treasury is about to bring back the 30 bond. If demand for 10 year bonds weakened in favor of 30 year bonds, we could very well see markedly higher interest rates for mortgages.

How, you ask? Well, many mortgages are aggregated and packaged as 10-year bond offerings on the MBS (Mortgage Backed Securities) market. They typically have a 10 year maturity because the average mortgage tends to be redeemed at that point, not 30 years. So, the reduced demand on MBS's could rais interest rates noticeably.

Some people might be asking at this point, "Is this for real, or just another hoax?" Well, it worked the same way in reverse. When the 30 year was discontinued, demand for the 10 year jumped substantially and they yields (along with mortgage rates) went in the crapper.
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