As the fixed-income markets embark on a new year and Alan Greenspan's tenure as chairman of the Federal Reserve draws to a close, the future paths of the US economy and Fed interest rate policy have become hot topics.
Central to the debate is the issue of inflation: in the aftermath of Hurricane Katrina, oil prices rose to new highs ($70.85 per barrel on August 30, 2005), and as most other energy and commodity prices climbed to elevated levels, so headline inflation has soared upwards. In September, the consumer price index (CPI) stood at a 14-year high of 4.3%. Although core inflation measures - which eliminate products that can have temporary price shocks, such as energy and food - have been reasonably stable in recent months, the Fed remains concerned about inflation.
Determining the impact of inflation on corporate credit is tricky due to complex macroeconomic interactions. Nevertheless, according to recent research from rating agency Standard & Poor's, correlation analysis suggests that higher inflation - taken as a surrogate for higher pricing power - should imply better earnings, help hold down the incidence of corporate defaults, downgrade activity and distressed debt, and place upward pressures on corporate bond yields and spreads. At the same time, nominal bond returns should deteriorate as yields rise. In short, higher inflation is a plus for credit quality since higher pricing power can boost margins, but is a negative for bond returns. As a result, S&P argues: "If a higher inflation environment does materialise in 2006, then this reduces the attractiveness of nominal bonds versus inflation-protected securities."
The future path of inflation is more likely to hit credit in the form of its impact on interest rate policy. Greenspan's successor, Ben Bernanke, is an outspoken supporter of inflation targeting - the setting of a formal goal for a low inflation rate that the central bank is committed to meet. Bernanke has already been involved in moving the Fed towards a more formal inflation objective, popularising a 1-2% "comfort range" for core inflation.
Although analysts say that Bernanke is unlikely to make any radical policy changes in the short run, higher-core inflation raises the odds of more Fed tightening, despite the slightly less hawkish view of inflation expectations in the minutes from the November meeting of the Federal Open Market Committee. Still, the minutes note: "Upside risks to the outlook for underlying inflation remained a key concern ... There was a risk that the large cumulative rise in energy and petroleum product prices through the summer would be transmitted to core consumer prices."
Conrad De Quadros, economist at Bear Stearns in New York, says: "We do not think that a Bernanke Fed would necessarily seek to stop at neutral in the event that core inflation is outside his 1-2% comfort zone if growth remains above trend and the unemployment rate falls below 5%."
Indeed, voting president Michael Moscow of the Chicago Fed said recently: "There is another very important point to emphasise: even if the funds rate were at neutral, further changes in policy might be appropriate."
So what, then, of the outlook for inflation? Although swings in energy prices stemming from the hurricanes and strong demand have played a role in keeping headline inflation elevated, thus far core inflation has not risen in tandem. But in recent months, says S&P, a spate of signals in non-energy commodity prices have been enough to suggest the potential for an increase in core inflation in the year ahead.
For one thing, the October 2005 US CPI report showed a slightly higher-than-expected increase - 0.2% - in the headline number, accompanied by a similar increase at the core level. De Quadros explains that this is partly because companies are finding it easier to pass on higher energy prices in the form of higher prices for goods.
The latest National Association for Business Economics survey showed that more firms raised rather than lowered prices in October, with the proportion of companies raising prices jumping to 38%, the second highest in the survey's 24-year history. Firms reported that they "found customers more accepting of, or more resigned to, price increases than earlier in the year".
In the short term, De Quadros expects measures of core inflation to trend higher as higher energy prices feed into the system, pushing prices of commodities and intermediate goods higher. "There have also been some recent pressures from the labour market. Unemployment is relatively low, so there has been a pick-up in unit labour costs," he says.
But David Rosenberg, North American economist at Merrill Lynch, says: "We have said it before and we shall say it again: the key to next year's economic and financial market performance hinges on the Fed not overreacting to the perceived inflation threat. The critical measure for the Fed next year should really be inflation expectations. This is more like looking through the front window instead of the rear-view mirror."
What is striking and important about the economic picture in 2005, says Rosenberg, is how similar the macro and market backdrop is compared with that of 1994. "Both years saw aggressive Fed tightening, a sharp Treasury curve flattening and rising bond yields. Despite solid earnings and GDP growth, both years saw sloppy and generally flattish equity market performance." The reason for this in both years was a backdrop of Fed-induced liquidity drainage and heightened inflation concerns, due to an upturn in oil and raw industrial commodity prices.
"In 1995, core inflation rose about half a percentage point," says Rosenberg. "If you had told that to an investor at the beginning of 1995, they wouldn't have wanted to touch a bond and yet 10-year yields rallied 200 basis points. That's because what really matters are inflation expectations, and these actually rallied 20-30 basis points in 1995. The Fed then cut rates and core inflation came back down the following year, so it's just a question of how forward- or backward-looking the Fed wants to be." Rosenberg predicts that the Fed will watch inflation expectations from surveys of economists and corporations, and also break-even levels in the Treasury inflation-protected securities market.
By early December, US Treasury yields showed that investors were the most confident about the outlook for inflation since Hurricane Katrina sent oil prices to record highs. The gap between yields on 10-year Treasuries and equivalent US inflation-linked debt narrowed to 2.37 percentage points on December 2, the smallest spread since late August, shortly after the storm hit the Gulf Coast, wrecking oil rigs and refineries. The difference in yield represents the average rate of inflation traders expect over the life of the securities.
The Fed has since raised interest rates twice, and oil prices have dropped 19% after reaching their record high on August 30. "The market is reflecting that the Fed has a lot of credibility on inflation fighting," says one Tips (Treasury inflation-protected securities) trader, who asked not to be named. "The recent retreat in energy prices has calmed the threat of inflation."
Rosenberg agrees: "Inflation is a lot like Elvis: lots of reported sightings, none confirmed. Now that the post-Katrina shock has been absorbed, inflation is going to melt along with the snow heading into the spring and summer."
By the end of 2006, Rosenberg predicts that both headline and core inflation will be firmly ensconced below 2%. "Our underlying assumption for oil is close to $50, so it remains at historically high levels, but it will provide an overall downward drag on the headline number. My sense is that ex-energy inflation is well-contained, albeit with some offsetting forces."