The Fed Makes an Easy Promise to Keep

by: Zacks Investment Research

In its statement last Wednesday, the Fed said:

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent, and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

With the release of the July Consumer Price Index numbers, that looks to be an easy promise to keep. The headline CPI was unchanged, and if one strips out volatile food and energy costs, the index was only up 0.1%. On a year-over-year basis, headline consumer prices were down 2.1%, the biggest decline since 1950.

Of course, much of that decline was due to the collapse in oil prices last fall. However, year-over-year core inflation was just 1.5%. That is not exactly hyperinflation, folks. Last month, headline inflation was 0.7% and core inflation was 0.2%, so on both fronts inflation is actually falling.

Unfortunately, it will probably not last, particularly on the headline side, since gasoline prices pulled back during July from a surge in June (but have since been on the rise again). Signs that the world economy is bouncing back, such as stronger numbers coming out of Europe and China, are likely to keep some general upward pressure on oil and other commodity prices. So I would look for a divergence between headline and core inflation going forward, with headline higher than core over the next year.

Food and Energy prices get more attention than the other prices in the CPI, but actually Housing carries a much bigger weight in the index. There prices are very well under control. Not exactly a shock given the plunge in the Case-Schiller Index and from the direction of median prices coming out with each Housing Report from the National Association of Realtors.

However, according to the government, the price you pay for your house has nothing to do with inflation, at least not directly. Rather, it assumes that you are renting your house from yourself, and so it is the change in rents that really matters. Rents have been starting to come down for apartments (often disguised as months of free rent and other inducements) but not as fast as have housing prices.

With very high vacancy rates for apartments, and lots of cash flow investors buying up previously foreclosed homes, the supply of rental housing is very high and this should continue to pressure rents downward. This should make life tough for the residential-oriented REITs like Equity Residential (NYSE:EQR) and Apartment Investors (NYSE:AIV).

As a general rule, you want to invest in areas where the relative prices are rising, unless it looks like the trend will reverse. Thus, if the end of the worldwide slump means higher demand for commodities like copper and iron ore, it is worth looking into companies like Freeport McMoRan (NYSE:FCX) and Brazilian mining giant Vale (NYSE:VALE).

One area where prices have consistently been rising faster than average is Health Care, which was up 0.2% for the month -- matching its increase in June -- and is up 3.2% year over year. The fear is that government action will cause that to stop, which while good for the country (some would say vital, even) would not be particularly good for the companies in that sector. As a result, it now trades at the lowest P/E of any sector, based on consensus expectations for both this year and next.

While we will probably get some sort of Health Care bill, it is looking more and more like it will be an extremely watered-down one. This is providing a wonderful opportunity to get into some extremely high quality stocks like Johnson & Johnson (NYSE:JNJ) at bargain prices.