Import prices are an important driver of inflation
The Bureau of Labor Statistics releases its U.S. Import and Export Price Indices monthly. The report keeps track of import prices by locality, type, and fuel/non-fuel. It also separates commodities and non-commodities. Commodity prices tend to be more volatile than non-commodity prices, so it makes sense to strip them out to get a view of underlying inflation. The U.S. inflation indices, the Consumer Price Index and the Producer Price Index, do the same thing – they give the headline number, then strip out food and energy.
Inflation is not the Fed’s biggest concern at the moment – if anything they are worried that inflation is too low. They have referred to failing on both sides of their dual mandate, which means it is not enough to keep inflation low, if it is too low it needs to be increased. This makes sense when you think of monetary policy at the zero bound. With interest rates as low as possible (they can’t go below zero), falling inflation (or even deflation) causes real interest rates to rise. Real interest rates are simply nominal interest rates (the rates you read in the Wall Street Journal) less the inflation rate. Deflation in the context of zero percent interest rates is the exact problem Japan has.
Highlights of the report
U.S. import prices fell 0.5% in April, after declining 0.2% in March. Both fuel and non-fuel imports contributed to the decline. Import prices fell 2.6% year-over-year, the largest drop since July. Fuel prices fell 1.7% in April as the 1.9% decline in petroleum offset an increase in natural gas. On an annual basis, fuel prices fell 7.8% and have not recorded an annual increase in over a year.
Non-fuel prices fell 0.2% after falling 0.1% the previous month. About the only category reporting an increase was consumer non-durables. Most commodities were down.
Impact on mortgage REITs
Given the muted growth in import prices (partially driven by a stronger dollar), the Fed is anticipating keeping interest rates as low as possible and using other tools, like asset purchases (quantitative easing), to try and spur some economic growth. So far, there has been no evidence of inflation, primarily because there has been extremely modest wage inflation. The classic “wage-price spiral” doesn’t really work when wages are not cooperating.
This means that the mortgage REITs, like Annaly (NLY), MFA Financial (MFA), American Capital (AGNC) and Hatteras (HTS), will continue to operate in the same environment they have had for the last several years – low returns on assets combined with low borrowing costs. Prepayment burnout has become evident as pretty much everyone who can refinance already has. At this stage, prepayments will be driven by home price appreciation and policy. If the Obama Administration implements the rumored HARP 3.0, where the dates for HARP eligibility are extended from mid-2009 to the end of 2010, a wave of refinances will be triggered that could hit the REITs. Otherwise, it will be more of the same, at least until the Fed starts winding down its asset purchase program, which will probably be some time in 2014.
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