Why falling wholesale inflation worries the Fed and affects REITs

Market Realist

The Producer Price Index measures inflation at the wholesale level

Inflation at the wholesale level has been typically taken to predict inflation at the consumer level. In a normal business environment, producers pass these increased costs to consumers, which would decrease the disposable income if wages didn’t rise accordingly. A little inflation is considered a good thing. Deflation causes a lot of economic problems, especially for the Fed. Since interest rates can’t go below zero, if deflation increases, it causes real (inflation-adjusted) interest rates to increase, which is exactly what we don’t want to see in a depressed economy.

Inflation is also a debtor’s best friend. As inflation increases, wages and prices increase, which means that the relative size of the debt decreases. Given the shaky state of most household balance sheets, the Fed would really like to create inflation, provided it results in increased wages. If wages don’t co-operate, the Fed could end up making matters worse. If commodity prices increase while wages stay flat, consumers end up with even less disposable income.

Increasing inflation has historically meant that the Fed was getting ready to raise interest rates. A disappointing inflation report would cause stocks and bonds to sell off as investors react to a tighter Fed. These days, the Fed isn’t overly concerned about inflation. As long as unemployment is elevated and inflation is below 2%, the Fed will consider itself to be failing at both of its mandates—price stability and unemployment.

Prices at the wholesale level fall as prices at the consumer level rise

The PPI fell 0.2% in May after rising 0.6% the month before. Ex-food and energy fell 0.1%. Interestingly, consumer prices rose more than expected, with inflation at the consumer level topping 2%.

This report will probably give the Fed pause. The Fed still fears deflation and will maintain ultra-low interest rates and continue with asset purchases until unemployment falls below 6%. That said, the Fed prefers to use the Personal Consumption Expenditures index to measure inflation, not PPI or CPI.

Implications for mortgage REITs

Low inflation means the Fed will be able to maintain short term-interest rates at low levels for the foreseeable future. This means mortgage REITs like Annaly (NLY), American Capital Agency (AGNC), MFA Financial (MFA), Capstead (CMO), and Redwood Trust (RWT) need not fear an increase in their borrowing costs—at least in the near future. Provided the long end of the curve stays the same (and the ten-year curve seems to have found a range here), their net interest margins should remain robust, and they should be able to maintain their dividends. Investors who wish to make a directional bet on interest rates should look at the iShares 20-year bond fund (TLT).

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