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May 19, 2005

Inflation Rising
by Chad Hudson

Over the past week, there has been a little bit of news that everyone can hang their hat on. Last week, the government reported that retail sales were strong. However, the University of Michigan consumer confidence survey unexpectedly fell 2.4 points. This week, producer prices were higher than forecasts, along with consumer prices, except for the core inflation rate. Industrial production dropped, but housing starts rebounded strongly. Most of the retailers have reported strong earnings, but there have been enough exceptions.

Industrial Production dropped by 0.2% in April from March, but was 3.1% higher than a year ago. This was the slowest year-over-year growth since February 2004. It needs to be remembered that the year-over-year growth has started to moderate because the comparisons are no longer against depressed levels. In fact industrial production reached it highest level in March and has increased by 8.0% over the past two years.

The Empire State Manufacturing Survey, published by the New York Federal Reserve fell to -11, the lowest level in its short existence. Almost every component of the survey showed contraction except for prices. As weak as the survey was, the expectations six months ahead only dropped 1.6 points. Ironically, almost every component increased except for prices. This survey was completed during the first two weeks of the month. Prior to the employment report, much of the economic spin was decidedly negative. A few other surveys will be published over the next week. It is likely that the response will be more favorable following the stronger than expected employment report.

Last week the Labor Department reported that import prices rose 0.8% in April from the prior month and 8.1% from a year ago. The year-over-year change in import prices has been greater than 5% since last May, which ties the duration during 1999 and 2000. And it is not just due to higher oil prices. Import prices excluding petroleum increased 3.0% and have rose 5.5% over the past two years - the largest increase since early 1996.

Higher import prices are driving producer prices higher as well. The Producer Price Index rose 0.6% in April, more than the 0.4% increase forecasted by economists. The year-over-year increase was 4.8%. While the increases decelerated from the previous month, the same dynamics discussed regarding industrial production are relevant. Over the past two-years producer prices have jumped 8.6%. This was the second largest two-year increase in prices since February 1991 (for two-year period ending November 2004 prices were up 8.7%).

Producer prices will likely continue to advance. Besides energy costs, the price of steel has been another large component of higher material costs. Since October, steel prices have moderated, albeit from very elevated levels, but might be headed back up. Nucor's CEO, Daniel DiMicco, said he expects steel prices to rebound starting "in the next month or two." He said the recent drop in steel prices was due to service centers working down their inventory after hoarding steel late last year. He said that demand remains strong among end users. Also weighing on the price, DiMicco said, was the 30% jump in imported steel during the first quarter.

So far producers have been absorbing a significant amount of the price increases. Consumer prices were 3.5% higher than last year and 0.5% higher than the previous month. Instead of focusing on the highest year-over-year increase since 2001, the bond market was relieved that the core rate was unchanged from March and increased only 2.2% from last year. This was the second consecutive lower year-over-year increase after accelerating for the past year. Consumer inflation started picking up in 2004. During the first half of 2004 the consumer price index rose 2.9% and held steady during the rest of year, rising only 0.3% during the second half of 2004. During the first four months of 2005, the CPI has risen 2.2%. For the two-years ending April, consumer prices have increased 5.8%. This two-year increase is the largest since the two-year period ending September 2001. Oh yeah, according to the CPI report, housing costs increased 3.2% from last year, with the owners equivalent rent rising only 2.3%.

Retail stales were strong, up 1.4%, twice the increase economists forecasted and the strongest month-over-month increase since September 2004. Retail sales excluding autos rose 1.1%, more than twice the 0.5% predicted. Strength was broad based with sales increasing in all but two industry segments. The year-over-year increase dropped slightly to 7.2%, but this is on top of a 10.4% increase last year.

Much of the economic weakness in March was blamed on the weather. While this is usually not more than a simple excuse, the commentary from Lowe's substantiates the reasoning. The home improvement retailer noted that its outdoor sales were strong in February and April, but weak during March. Additionally, Lowe's said that its sales of seasonal heating products were up 97% from last year. Lowe's along with Home Depot said that appliance sales were strong.

Wall Street was critical of the results from two retailers. Earnings fell over 50% at Limited Brands. The drop was due to trying to shift styles at its Express stores. According to the company it "aimed at a wear-to-work component of our assortment as well as trading our customer up through better quality, and as a result, higher average unit retail has clearly not worked. We got fashion wrong, we drifted older, we drifted more expensive, and in fact, alienated a large percentage of our total customers." This snafu resulted in comparable store sales plummetting 21%. Lower sales also resulted in an inventory overhang which will hamper margins during the current quarter as the company lowers prices in order to move out the merchandise. Analysts were also concerned about Abercrombie & Fitch. While sales were strong, up 33%, inventory soared 72%. It is interesting that while total inventory rose 72%, it was only up low double digits in terms of units. The average unit increased in price by 23%. It should be clear that consumer spending remains strong if a retailer is able to increase its average ticket by 23%.

The economic data appears to show an economy that is undergoing wavering. However, the inconsistent data is more attributable to the unbalanced nature of the current economy. With long-term interest rates recently falling back to near thirty-year lows, this will only prolong this imbalance by fueling the housing market, which in turns fuels consumer spending.

Chad Hudson
Mid-Week Analysis
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