The Dow Still Doesn't Have to Worry About Inflation

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

The stock market returned to the upward trend it has seen throughout much of the week as investors stopped worrying about the lingering concerns of potential military conflict in the Middle East and next week's meeting of the Federal Open Market Committee. Instead, shares overcame some mixed readings on the economy, with investors seemingly focused on the longer-term trends toward improving economic conditions that have provided a foundation for accelerated stock-market gains for nearly a year now. At 12:10 p.m. EDT, the Dow Jones Industrials (DJINDICES: ^DJI  ) were up about 67 points.

Ordinarily, in an economic recovery, pressures to raise prices would start to appear, awakening fears of inflation and prompting policymakers to tighten their stance on monetary policy. Yet inflation has largely been absent during this recovery, and while the latest reading from the Bureau of Labor Statistics on producer prices showed a modest increase in its headline number, a deeper look at the report should allay any concerns that rising inflation will force the Fed's hand.

The latest on the PPI
August's PPI report included a 0.3% gain in prices for finished wholesale goods overall, roughly splitting the difference between July's flat reading and June's 0.8% gain. Rises in energy costs accounted for about two-thirds of August's overall increase in the PPI, as gasoline prices jumped 2.6%. In addition, a nearly 27% surge in prices of vegetables pushed overall food costs up 0.6%. Taking those volatile segments out of the equation led to a flat reading in the core PPI.

But arguably even more encouraging are the moderating trends that we've seen earlier in the supply chain. Prices for intermediate goods were unchanged for the second month in a row, continuing their trend of untroubling results. The best news came at the crude-goods level, where a 2.7% decline offset increases in two of the past three months and brought year-over-year gains down to just 1.6%. Food prices at both the intermediate and crude level fell sharply, decreasing any concern about the increase in the finished-goods food segment. Falling natural-gas prices also helped pull down crude-level energy costs.

Will price stability stay the Fed's hand?
Interestingly, persistently low levels of price increases have switched the polarity of policymakers' concerns about inflation. Earlier this year, St. Louis Fed President James Bullard argued that inflation levels are too low in comparison to the Fed's long-term inflation target of 2%. Bullard believes that the widely anticipated tapering of bond-buying under quantitative easing would need to be rethought if inflation remains too low. Even Philly Fed President Charles Plosser has recognized the importance of not letting inflation fall too far, although he doesn't share Bullard's immediate concerns about the threat.

Continued Fed bond-buying in defiance of the market's tapering expectations could have huge positive impacts on financial stocks. Wells Fargo (NYSE: WFC  ) and Bank of America (NYSE: BAC  ) have both recently announced job cuts as a consequence of weaker mortgage-lending activity. Mortgage rates have risen in large part due to the expected halt of Fed purchases of mortgage-backed securities, but if QE continues at its current pace, a reversal in those rates could help preserve the mortgage business at those and other banks. With Wells having posted $2.8 billion in mortgage income just in its second quarter and B of A reporting $1.2 billion in mortgage-banking profits, the industry has a lot at stake.

Moreover, financial companies have big bond portfolios that could also benefit from lower rates. JPMorgan Chase (NYSE: JPM  ) said earlier this week that continued rises in bond rates could cost it as much as $15 billion in losses on its bond holdings. A downturn in rates, on the other hand, could produce big profits.

Watch the Fed
For the next week, all eyes will be on Fed officials as they meet to make what could be a landmark decision about the future course of monetary policy. Much of their eventual decision could hinge on how they interpret inflation figures like the PPI's recent modest gains.

Bank stocks could see some big moves in the wake of the Fed's decision next week, but despite big share-price gains over recent years, many bank stocks still look cheap if you know where to seek the best value prospects. The Motley Fool's new report "Finding the Next Bank Stock Home Run" will show you how and where to find these deals. It's completely free -- click here to get started.


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