Tepid Inflation Supports the Stock Market, But Will Prices Rise Soon?

The Dow Jones Industrials (DJINDICES:^DJI) had bounced a modest 35 points as of 12:30 p.m. EDT Friday. Although much of the attention in the market focused on the tech sector, benign readings on inflation from the latest Producer Price Index update also contributed to the positive mood to Wall Street. Yet the question facing investors is whether May's reading is already out of date, and whether the price pressures on the energy front that have boosted shares of Dow components ExxonMobil (NYSE:XOM) and Chevron (NYSE:CVX) will work their way into higher inflation generally.

Prices pull back
After two straight months of sizable increases in the Producer Price Index, some investors were nervous about what May's numbers would bring. But a drop of 0.2% for the overall final-demand number brought the year-over-year increase for the measure of wholesale inflation back to the 2% level that the Federal Reserve targets as its desired baseline.

The new methodology for the Producer Price Index looks at goods and services separately, and for May, both measures fell 0.2%. On the services side, a drop in margins received by wholesalers and retailers accounted for most of the decline, even as transportation and warehouse services got more expensive. Among goods, gasoline prices declined 0.9%, contributing about half of the overall drop. Food prices were mixed, with pork and cheese falling but poultry climbing.

A taste of things to come?
Further down the supply chain, though, a few hints of possible inflationary pressure attracted the attention of more nervous investors. Although broad measures of intermediate demand remained in check, pockets of higher prices surfaced, especially in unprocessed energy-related goods. Crude oil, natural gas, and coal prices all rose.

Importantly, the Producer Price Index data all came from before the recent troubles in Iraq. Energy traders have pushed prices of crude even higher in response to the escalating conflict, and ExxonMobil, Chevron, and other energy stocks also fared well even as the Dow Jones Industrials more broadly have suffered from a loss of investor confidence. A sustained conflict in Iraq could cause crude-oil supplies to drop, and that in turn could raise prices high enough to affect not just direct costs of energy products but also associated goods whose producers have enough pricing power to pass through higher transportation expenses.

For now, inflation appears far from imminent, especially given the moderating influence that including services in the Producer Price Index has had on its overall level. But investors should keep a close eye on Chevron and ExxonMobil as barometers of the energy sector, keeping in mind the way that more-expensive fuel costs can work their way across the entire economy.