Fear of 'reflation' spooking Wall Street?

WASHINGTON – It's official: Wall Street, like a lame horse that smells a distant wolf, is spooked. By what, no one's quite sure.

Some say it's by the never-ending terrorist threats. Until Osama bin Laden is caught, more and more investors feel the best place is on the sidelines, despite the economic recovery.

Others say the market is more worried about phony corporate earnings after the Enron and WorldCom accounting scandals – and promised new federal red tape to curb such book-cooking.

Still others add a third specter: "reflation," or the rekindling of that old nemesis, inflation. The markets, which typically anticipate economic trends six months out, could be seeing higher interest rates in the offing, which would slow the recovery.

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It's not an irrational fear. Central bankers, responding in part to the Sept. 11 shock, cut the federal funds rate by more last year than they have at any time since 1958 – to 1.75 percent from 6.5 percent, compared with 0.63 percent from 3.5 percent 43 years earlier.

And the money supply, as broadly measured by MZM, grew faster in 2001 than it has since 1983. (MZM, or Money Zero Maturity, is M2 minus total small-denomination time deposits, plus institutional money funds.)

Analysts note that price pressures are already building in the production pipeline. Over the past three months, core crude materials prices shot up more than 28 percent at an annual rate, according to the Labor Department, while core intermediate goods prices increased more than 2 percent.

What's more, the Commodity Research Bureau's futures index is up nearly 14 percent since October, while the dollar is down nearly 12 percent from its January peak.

Some market economists warn that the longer the Federal Reserve waits to tighten credit, the more inflationary pressures will build. The threat of deflation has long passed, they say, and the economy is entering a period of easy money thanks to an over-accommodative Fed. And too much money sloshing around the economy may soon stoke inflation, despite continued big gains in labor productivity.

"The Fed is excessively easy, and fears of inflation are not far from becoming reality," said Brian S. Wesbury, chief economist with Griffin Kubik Stephens and Thompson, a Chicago investment firm.

He says a recent spike in gold prices reflects much of that anxiety over reflation. (One of the country's top bond forecasters, Wesbury sees a 10-year Treasury yield of 5.8 percent and a fed funds rate of 2.25 percent by year-end.)

Since bottoming at $256.60 a troy ounce on April 2, 2001, gold prices have soared nearly 30 percent to a four-year peak of almost $330 an ounce last month. The spot price has since settled back to about $314.

Others argue that even a $330 level is not historically significant, since gold broke above $400 throughout the '80s and '90s – though the recent sharp rise may be significant, mirroring as it does the run-up to the 1987 stock crash.

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Gold spiked after Sept. 11, then retraced gains as the panic subsided, gold-watchers say. Then, after President Bush's "axis of evil" speech in January, gold took off again, as saber-rattling over Iraq grew louder. Gold bugs worried about an oil embargo and crude-driven inflation from a Middle East war, analysts say. The Israeli-PLO conflict heightened those fears, and gold prices climbed even higher.

But as tensions in the region have eased over the past several weeks, so have gold prices.

The mild gold rush, combined with the chronic slide in stocks, has whet the appetites of the perma-bears, who are always quick to predict gloom and doom. They are coming out of the woods in droves. Many are drawing parallels (once again) to the 1929 crash and Great Depression.

The Zeal Intelligence newsletter, for instance, says the Nasdaq bear, started in 2000, is tracing the same pattern as the Dow bear that began in 1929. It warns clients that, based on that comparison, the Nasdaq is a long way from bottoming.

Indeed, the Nasdaq has lost 73 percent of its value since its March 2000 peak, and there's no floor in sight. The S&P 500 index is testing 1997 lows and has shed 40 percent of its value since 2000. The Dow, moreover, has fallen back into the Sept. 11 crater it had dug out from, falling below 9,000 for the first time since Oct. 2.

But the problem with such historic comparisons is the variables are never the same.

What led to the 1929 crash was a blend of circumstances unique to that period, a formula for disaster that can't be replicated today. That's not to say the magnitude of financial disaster that occurred then won't happen again. It's just that the events that would trigger it can't be predicted based on what happened nearly 73 years ago.

And although the markets aren't reflecting it, economic fundamentals appear to be sound.

Housing starts are still strong, thanks to low mortgage rates. And many builders and
building-materials suppliers, such as Charlotte Pipe and Foundry, which makes the white PVC drain pipes in many of the new homes across the country, were never hurt by the recession. They kept making money.

Productivity, moreover, is steadily improving again, and jobless claims are down.

And the economy grew a blistering 6.1 percent in the first quarter.

As more companies report second-quarter earnings over the coming weeks, Wall Street will get a sense of how durable the recovery is. If reports are good, it may be the boost stocks need – assuming, that is, investors can trust the numbers.

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