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Higher Energy, Housing Prices Thrown in the Mix for Transition Year

BY KATE BERRY


To Scott Anderson, senior economist at Wells Fargo & Co., the Federal Reserve has just taken away the punch bowl from a crowd of thirsty partygoers.

The punch, of course, is cheap money that businesses have been feasting on to chase higher returns in emerging markets such as China and India. But inflation is breaking up the party, posing a challenge to U.S. economic growth.

Anderson and other economists now expect the Federal Reserve will raise its benchmark short-term interest rate to 5.25 percent at its June meeting, marking the 17th consecutive interest rate hike in the past two years.

“People will feel it,” Anderson said.

Higher energy and housing prices already are taking their toll. He expects U.S. economic growth will pull back to a 2.7 percent clip in the second quarter, down from 5.3 percent in the first quarter.


Question: Suddenly everyone is talking about inflation. What’s going on?

Answer:
We’re telling clients to fasten their seat belts; 2006 is going to be a transition year. We’re going to see delinquency rates and foreclosures increase for the next few years. Much of the concern centers on the consumer price index. The numbers this month were pretty clear , they showed a terrible inflation number. (The CPI has risen at a 5.2 percent annual rate so far this year, up from 3.4 percent last year.) That’s going to weigh on market performance. The economic numbers just are not very comforting. It looks like the Federal Reserve will raise interest rates in June and they’re likely to raise them again in August, though there’s a lot of data between then and now.


Q. Consumers have already felt the pinch from energy prices, so what is the Fed focused on?

A.
The Fed has gotten more vocal about inflation in the last couple of weeks in anticipation of more data coming out. Just a month ago, (Federal Reserve Chairman) Ben Bernanke was talking about containing core inflation. Now that’s gone out the window. A lot of factors are playing into the Fed’s concern. One is the fact that “capacity utilization” , that’s the amount of capacity that is actually being put to work in the manufacturing sector , has gone above 85 percent, which is bad. That’s when bottlenecks occur in manufacturing that drive prices higher. It’s viewed as a gauge of wage and price pressures. And there are other signs in commodities of prices hitting record highs.


Q. What about housing?

A.
We’re seeing upward pressure on rents right now, which make up 40 percent of the core CPI index. The weakening housing market is adding to some pressure on rents. But there’s debate as to whether it’s a true inflation signal. The fact that energy prices have been so high for so long has taken many on the Federal Reserve Board by surprise. Businesses were temporarily able to hold off on price increases and hold off raising prices. But now they’re passing through higher prices in order to maintain profitability. That’s why we’re seeing airlines raising prices.


Q. Energy prices are up 30 percent for the first five months of the year. Why wasn’t the Fed concerned about this earlier?

A.
What has masked the effects on the economy is that home prices continued to accelerate at double-digit rates. If you see the amount of money people have taken out of their homes, it almost mirrors what people have paid in higher energy costs. But that’s not likely to reoccur. If we get further spikes in energy, we won’t have the cushion of refinancings.


Q. What’s the likelihood that banks and mortgage lenders face trouble ahead?

A.
There’s going to be some mortgage lenders and borrowers hurt by what’s occurring with the rate environment. A lot of borrowers are overextended. They bought houses that they could not afford. With home prices slowing down, many families can no longer count on appreciation. But it’s going to be a long process because not all mortgages are going to adjust this year. Rate increases will hit the sub-prime market first and those are the households vulnerable to interest rate hikes because of high debt levels and high gas prices.


Q. Do you think a global recession is on the horizon?

A.
No. We think recent market turmoil is more a reflection of risk premiums returning to historic levels. We’ve just seen so many investors taking incredible risks for very little return. Now central banks are raising rates and we think this period of rampant liquidity and risk-taking may be over. What we’ve seen is that hedge funds and other sophisticated players have been focused on the “carry trade” , borrowing money in Japan and investing heavily in equity markets in China and India. The cheap liquidity is drying up and that’s leading to some liquidation. Emerging markets are leading the plunge in equities.


Q. Do you see some historic parallels?

A.
The current climate is similar to what the Fed did in 2000 to 2001, where they saw inflation pressures starting to emerge. Alan Greenspan called it “irrational exuberance,” and began raising rates at the same time that energy prices were rising. They ended up over-tightening, and the economy went into a recession with the dot-com bust. There’s still a possibility that could happen. The longer the market keeps selling off, the greater the chance of a blowback.


Q. There’s been a lot of negative talk about Bernanke’s role in sending the market lower.

A.
His comments have certainly opened him up to a lot of criticism. Certainly traders haven’t been shy about their concerns. They’re calling the FOMC (Federal Open Market Committee) the Federal Open Mouth Committee (laughs). This is all part of the learning experience that central bankers go through, and Greenspan went through it.


Kate Berry is a staff reporter for the

Los Angeles Business Journal.

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