The Economic Wild Card That Could Send the Dow to Record Highs

Although investors might be disappointed that the Dow Jones Industrials (DJINDICES: ^DJI  ) ended Friday up just 59 points after rising as much as 150 points earlier in the trading session, the market's ability to sustain current levels despite five years of huge returns is impressive. While many analysts pointed to the personal income and spending figures this morning from the Bureau of Economic Analysis as signaling the economy's resilience in the face of harsh winter conditions, one figure that most stock market investors didn't pay attention to has potentially bigger implications for the Dow's future and the direction of monetary policy well into the future.

Another measure of inflation
When most investors think about inflation, they tend to focus on the Consumer Price Index. But included with the personal income and spending figures from the BEA is another measure of inflation called the price index for personal consumption expenditures, also known as the PCE deflator. This morning's reading on the PCE deflator showed a 0.1% rise in February, matching January's 0.1% jump and bringing the deflator's rise over the past 12 months to just 0.9%.


The impact of runaway inflation. Source: Wikimedia Commons.

The PCE deflator is so important because the Federal Reserve prefers it to the CPI in determining changes in consumer prices. Back in 2000, the Fed switched to using the PCE deflator as its primary measure of inflation. Yet despite some conceptual differences that lead to different relative weighting of consumer-related expenditures -- especially for housing -- both the PCE deflator and the CPI have pointed to levels of inflation that have worried policymakers as being so low as to risk a potential deflationary spiral.

Why low inflation could help the Dow
The question investors have to ask is how low levels of price increases will affect their investments. For instance, declining prices for energy helped keep the PCE deflator in check last month, and a generally weak pricing environment has added to the difficulties that ExxonMobil (NYSE: XOM  ) and Chevron (NYSE: CVX  ) have had in producing revenue growth. Similarly, falling prices for durable goods could cause problems for the companies that manufacture and sell those goods, hurting their sales growth and eating into their profit margins.

What low inflation does support, though, are measures intended to stimulate the economy. The Fed is pushing forward in reducing its bond-buying activity under quantitative easing, taking another $10 billion off its monthly bond purchases earlier this month. Yet even amid controversy about the potential for raising short-term interest rates sooner than expected, it's apparent that the Fed has more latitude to keep rates low for a longer period of time, not less. That could be good news for JPMorgan Chase (NYSE: JPM  ) , Wells Fargo (NYSE: WFC  ) , and other banks that stand to profit from a steep yield curve reflecting the difference between low short-term rates and higher (though still low) long-term rates.

Keep your eyes on inflation
Eventually, economic growth might accelerate to the point at which inflation becomes a concern. For now, though, the PCE deflator only confirms the impression that economists have had for a long time that the economy has plenty of capacity for growth before price pressures come back. That latitude could help support record gains for the Dow in 2014 and beyond.

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