Prices shock raises fears for US rates

A JOLT of economic reality suddenly shook the US markets on Friday, sending the stock market down by nearly 200 points. After months of barely even thinking about price rises, equity analysts were shocked by a rise in the consumer price index for April of 0.7 per cent, the fastest since this period of economic expansion began.

Ahead of tomorrow's meeting of the Federal Reserve's Open Markets Committee, the figures suggested to the markets that rising interest rates may not be far away. Alan Greenspan, the Fed chairman, himself said in a recent speech that inflation could not stay as low as it has done forever.

This shift in sentiment about interest rates was cemented by remarks at the weekend by Lawrence Summers, the designated successor to Robert Rubin as Treasury Secretary. "A strong dollar is very much in America's national interest" as it had helped to control inflation, Mr Summers said.

By far the largest component of the prices rise was a 6.1-percentage point increase in the energy index as oil prices start to respond to increased producer discipline. Without energy and food, core consumer prices rose by 0.4 points - an annualised inflation rate of 2.3 per cent based on the first three months of the year - compared to 3.9 per cent for the whole consumer prices index.

But there was more bad news. Other components of the index were also rising - tobacco, clothing and medical care, for instance. And low oil prices have been a key factor behind the expansion.

Earlier in the week, the bond market had taken some heart from the continuing low levels of producer prices, which rose by 0.5 per cent in April, but only by 0.1 per cent excluding food and energy. Wage rises were moderate and retail sales relatively soft, and other indicators also encouraged bond traders to believe that there was some softening in the economy.

Bond prices had surged after nearly a year of rising yields. The yield on the benchmark 30-year Treasury actually fell back below 5.75 per cent, only to head back to nearly 6 per cent on Friday.

But there has been no doubt about the bond market's general direction for months. The yield on the 30-year bonds has now risen by a full percentage point since early December. The Federal Reserve has started to indicate that it might move towards a presumption in favour of tightening.

In his speech 10 days ago, Mr Greenspan noted that "there are imbalances in our expansion that, unless redressed, will bring this long run of strong growth and low inflation to a close".

The Fed chairman is always careful to point out that he does not completely understand why and how the expansion has continued as long as it has. The markets are not so scrupulous. The equity market has powered ahead, with the Dow Jones rising by 20 per cent this year, even as bonds have been indicating their concerns about the coming rise in price levels and the possibility of a shift in Federal Reserve policy. It may be that some catching up is in order.