Don't Worry, Be Happy Economic News (Fool Plate Special) August 13, 1999

An Investment Opinion

Don't Worry, Be Happy Economic News

By Matt Richey (TMF Verve)
August 13, 1999

Economic news continues to be the dominant force in the stock market with the report du jour being wholesale prices as measured by the Producer Price Index, or PPI. Foolish investors should spend the majority of their time focusing on bottom-up research of individual companies, but it never hurts to pay attention to broad economic forces, especially such fundamental issues as inflation.

This morning, the government announced that the PPI for finished goods advanced only 0.2% during July, which was lower than the market's expectations for a 0.3% rise. In addition, the PPI is now increasing at only a 1.5% annual rate. Stock index futures soared on the news, and the rally has extended into the morning. The bond market also liked the news, sending the 30-year Treasury bond yield down 13 basis points to 6.13%.

The stock and bond markets' jubilant reaction is out of relief that inflation continues to remain at bay despite strong economic growth and low unemployment. Throughout the 1990s, inflation has steadily declined, allowing our economy to prosper in an era of relative price stability. Stable prices create an environment in which businesses feel confident in making investments in new technology and new employees. Stable prices also are a direct cause for low interest rates, which encourage spending by both businesses and consumers. The end result has been soaring profits for Corporate America and a higher standard of living for all Americans. And, it all goes back to stable prices.

Alan Greenspan will tell you the same thing. The Fed Chairman has stated that stability in the general level of prices for goods and services is a necessary condition for maximum sustainable growth. Of late, Greenspan has been worried about potential imbalances from tight labor markets that could cause wage inflation and eventually inflation across all goods and services. The G Man has also voiced his concerns about the rapid increases in the stock market for the past several years, which has induced consumer spending from the so-called "wealth effect," which comes from seeing one's brokerage account balloon. Nevertheless, with all of the moving parts in our complex economy, Greenspan ultimately considers price stability to be the #1 goal for the Fed's monetary policy.

So with that backdrop, you can see why the markets were excited to see a lower-than-expected increase in the producer prices of finished goods. In fact, when you strip out the volatile food and energy prices, there was no increase in producer prices for July, and on a year-over-year basis, wholesale finished goods are increasing at only a 1.3% rate. The PPI report also included the prices of goods in the intermediate and crude stages of production, but those numbers are less relevant than the above finished goods numbers. As the name implies, finished goods are those that will soon be offered for sale to consumers, and thus finished goods prices are most relevant in predicting inflation at the consumer level. We'll get the exact inflation numbers on Tuesday when the government reports the Consumer Price Index, or CPI.

Actually, the PPI is not an especially good predictor of the CPI because the methodology in determining the two numbers is very different. While both numbers are used as a measure of prices, the PPI and CPI have distinctly different purposes. The PPI measures prices on the wholesale level, and thus only includes the producers' costs, which are limited to the inputs from which final goods are made. The PPI doesn't include such costs as sales taxes, which of course impact consumers and thus rightfully are included in the CPI. In addition, the PPI only includes the prices of goods, whereas the CPI includes the prices of both goods and services. Not surprisingly, then, the PPI tends to show a lower level of inflation than the CPI. Here's how the two numbers have stacked up over the past few years:

Annual Price Increases (not including food and energy)

         PPI       CPI
1995     2.6%     3.0%
1996     1.4%     2.7%
1997     0.3%     2.4%
1998     0.9%     2.3%
1999*    1.1%     1.8%


As you can see, inflationary pressures have been nonexistent in our economy for several years, and the situation only appears to be improving. It's Alan Greenspan's job to worry about potentially unstable imbalances in our economy, but from a longer-term perspective, one can see that we're living in an era of increasingly stable prices, which bodes well for economic prosperity, and thus the returns of individual stocks.