Why A Dose Of Inflation Is Good For You

By Daniel Kadlec

Something's wrong with this picture. Corporate profits are up; companies are spending again. More than a million jobs have been created since August, and economic growth should exceed 4% the rest of the year. The recovery bodes well for wages and job creation, even, at long last, for conservative savers who have been unable to find money-market yields much above 1% for several years. This is the good news we have all been waiting for. Yet Wall Street has been acting as if something were terribly wrong. Long-term interest rates are notching higher, a clear sign that some perceive the investment climate as riskier. The 10-year Treasury-bond yield hit 4.8% last Friday, up from 3.7% two months ago. Mortgage rates are jumping too. The Dow sank to its lowest level of the year last week, briefly dipping below 10,000.

The market is missing the point. Sure, the invigorated business world is producing the first whiffs of inflation since the Internet bubble, a turn that all but guarantees that the Federal Reserve will raise short-term interest rates this summer. In so doing, the Fed will bring down the curtain on a long easy-money period that has been marked by 0% car loans and giveaway mortgage rates. But for that to be bad news, rates would have to jump dramatically--and fast. A sharp spike in rates could kill the housing market, shut down business spending and slow the economy before the job recovery really takes hold. That's not likely to happen.

To be sure, once the Fed starts raising rates, you never know how far it will go. Stephen Roach, global chief economist at Morgan Stanley, says the Fed has been "irresponsible" in not boosting rates already. He is worried that a series of stiff hikes may be needed to make up for lost time. Uncertainty surrounding how far and how fast rates will rise is what has investors running for cover. But few believe the coming rate boosts will stop the recovery. Economists generally expect orderly rate increases that by the end of 2005 will have pushed the benchmark short-term Fed funds rate to about 3% from today's 1%. Such movement would "reflect healthy economic conditions and be welcome," says Hugh Johnson, chief economist at First Albany Capital. Provided that rates climb slowly, a growing economy can absorb the incremental costs because profits, income and jobs are also on the rise.

In fact, rising rates should be met with cheers, not jeers. They confirm the recovery. Companies can start raising prices, allowing them to start hiring again too. Business is so good at Pine Hall Brick Co. in Winston-Salem, N.C., that the company raised prices 3% in January--its first increase since 2001 for face brick used in housing--and plans a similar price increase next year. The company is doubling output at its Fairmont, Ga., plant and boosting head count 8%, to 320 workers. "We designed the plant to double capacity over three years," says president Fletcher Steele. "We're way ahead of any schedule that I would have expected."

Only a year ago, Fed chief Alan Greenspan openly fretted about deflation, a debilitating condition in which prices throughout the economy fall, wreaking havoc on profits, job creation and wages. That threat has clearly passed. Gasoline prices have jumped 20% this year. Other things are getting more expensive too, including milk, cereal, clothing, furniture and hotel rooms. Yet in most cases the increases have been marginal. Pet-food prices are up 3% to 6% this year, after three years with no increases. Computers and other electronics continue to get cheaper. The Consumer Price Index for April, reported last week, rose at an annual rate of just 2.4%. The kind of inflation that would provoke a dramatic Fed response is not in the cards anytime soon.

We should quit the hand-wringing. Stocks may have a rough period for a bit. Typically, stocks fall 1.3% in the two months after the first in a series of Fed rate boosts, reports Ned Davis Research. But stocks rise 5.1% the two months after that and keep going up. So look for opportunities to buy. Lighten up on bonds, which lose value as rates rise. Short-term bank certificates of deposit and money-market accounts still offer paltry yields. But as the Fed swings into action, the payouts on these short-term instruments will rise. As long as rates move up slowly, everyone can celebrate.