Wall Street in gloomy `inflation watch'

Inflation seems to be the flavor of the month on Wall Street. But when our librarian keyed the word ``inflation'' into the Nexis data base last week we got 346 references from the New York Times, The Christian Science Monitor, and Business Week during late April of this year. It was virtually identical to the same period in 1987.

Admittedly, that isn't the most scientific survey we could do. But it does indicate that worries about inflation are pretty constant.

It is not so much inflation, however, as the Federal Reserve reaction to inflation that is important. Fed chairman Alan Greenspan told Congress last week that 4 or 5 percent a year is still too high. The way the Fed attacks inflation is by tightening the money supply and raising interest rates. Higher interest rates spell trouble for the stock market and for the economy as a whole.

``We're heading for a period rising interest rates,'' says Ted Gemlich, manager of IDS Stock Fund for IDS Financial Services in Minneapolis. ``That's not good for bond or stock owners.''

The inflation watch is why the report Friday of another decline of the unemployment rate - to 5.4 percent in April - worries many investors, even though it is wonderful news for American workers. Investors see higher wages in the offing if businesses have to compete for workers. That's inflationary.

Largely because of these concerns, investors drove the Dow Jones industrial average down 24.87 points last week to 2,007.46.

``I don't think there's more need for genuine concern about inflation,'' says Thomas Williams, executive vice-president of Kemper Financial Services mutual funds in Chicago, ``but the perceived concern is quite high.''

In fact, wages and prices are not on a tear - at least not yet. Despite the falling unemployment rate, unions are getting, on average, only 2.1 percent increases in their contracts, according to Moody's Bond Survey. Energy costs remain moderate, with little prospect of a big increase soon, given continuing disarray in the Organization of Petroleum Exporting Countries.

But inflationary pressures may be building anyway. A Federal Reserve survey last week found that businesses were ``concerned about higher materials prices, especially for steel, paper, plastics and aluminum.''

And the capacity utilization rate for American factories and mines is creeping toward the danger line. A recent report in Value Line Investment Survey notes that when industry is running at 85 percent of capacity, this is considered inflationary. The current rate is 82.5 percent, but primary processors - metals, paper, textiles - are running at 86.3 percent, making ``continued growth without inflation difficult to achieve,'' Value Line says.

``I'd have to agree there is upward pressure on inflation,'' says William Fletcher, a portfolio manager at Independence Investment Associates of Boston, which manages about $3.5 billion in pension funds. ``Bond rates have been drifting up. Commodity prices have been rising strongly since last summer. The bond market is very nervous about inflation.''

One barometer he uses is the relationship between interest rates and price-earnings ratios. Higher inflation means that companies can raise prices. This boosts corporate profits and makes price-earnings ratios attractive. But this can only go so far. Eventually interest rates rise because of inflation. Fletcher sees the interest-rate P/E relationship as ``on the threshold.''

Cash (meaning short-term investments) is the refuge of the prudent investor. Mr. Fletcher's preference is short-maturity bonds. So is Mr. Gemlich's of IDS, whose $1.3 billion fund is normally at 8 percent cash but today is around 17 percent.

Mr. Williams at Kemper says it isn't inflation per se that concerns him. It's the likely Federal Reserve reaction, ``which isn't healthy for the bond or stock market.'' Williams considers the inflation picture still spotty, but he does think the economic cycle is coming to an end.

While inflation isn't a nice word, it alone does not cause the death of a business cycle, notes Geoffrey Moore, director of the International Business Cycle Research Center at Columbia University.

As an economy expands, he says, businesses have higher costs for labor and raw materials. Retail prices may rise, but they go up as fast - perhaps because of import competition or sluggish consumer demand.

``That puts a squeeze on profits,'' Dr. Moore says. Companies cut back on capital investment and lay off some workers. This is what causes an economic downturn.

Inflation actually lags the business cycle by four to six months, he says. It is easier to raise prices after business has been expanding and there are more jobs and personal income is increasing, Moore says. When the economy slows down, unemployment rises slowly and wages do not drop immediately.

If the pattern holds, inflation would worsen this year even if the economy were to cool. In other words, the stock market probably has obstacles ahead of it, not least the rising chorus of inflation concern in the press.