Market inflation fears are receding for the time being

The equity market continued its bear market rally this past week despite the increased international tensions stemming from the Russian attack on Georgia and all that development's dire long-term implications. The impetus for the further stock market rise was primarily the drop in oil prices, other commodity prices and the strengthening dollar. This positve set of price declines and currency moves overwhemed signs of economic deterioration in Europe and Japan, equity market prices declines abroad and evidence of increases in global inflation, especially in the US.

The Consumer Price Index jumped 0.8% in July for an alarming 5.6% spurt from a year ago. This is the largest increase in almost two decades, And yet the market acted as if the consumer price report actually indicated a surprise weakening in inflation. For example, the yield on Treasury notes and bonds, which moves up and down largely with inflation expectations, declined appreciably. The Treasury 10-year note yield fell to 3.84% on Friday from 4.2% just a few weeks back. The reason of course for a decline in inflation expectations (and Treasury yields) was a continuing decline in commodity prices, especially for oil and gold, and a strengthening dollar. In effect, the market believed that inflation expectations (which are forward looking), should respond to these variables and not the backward looking Consumer Price Index, which was largely boosted by energy and food prices. For without food and energy, the so called core Consumer Price Index was up a more restrained 2.5% from July last year.

With the global economy sliding toward recession, there is bound to be a decline in economic demand for basic resources and a consequent decline in price pressures. The European Union reports that GDP declined at a 0.8% annual rate in the second quarter. This expands the countries in or on the threshold of recession to the US, the UK, the EU, and Japan. Even China's economy shows signs of slowing down. Thus, it is reasonable to expect a general slowing of inflation during the recession and for some time into the recovery period as excess capacity and productivity gains restrain inflation.

But once the global economy is back on track, firmly into recovery and the excess capacity cushion is exhausted, inflation will reassert itself. Considering that the current recession promises to be prolonged, the return of inflation should not be considered a near-term prospect.

In the meantime, the recessionary forces of the housing debacle, credit crunch, consumer financial squeeze, financial institution distress, rising unemployment and curtailed consumer spending will eventually restrain inflation, These forces will also curtail corporate profits. That will ultimately lead to a renewed weakening in equity prices. The temporary improvement in equity prices of airlines and other firms benefiting from the decline in energy prices is just that, temporary.

Philip Braverman, President
Braverman Economic and Financial Consulting
One Hewitt Square #249
East Northport, New York 11731

E-mail address: philipbraverman@gmail.com