CPI Up, Markets Down, What Next?

David Altig brought out the current thinking of the Fed on inflation as written by John Berry. Basics: No inflation spiral, current level is too high but economy is moderating. Result: Another 25 in June as insurance, we will see about August. My thought: To accept this line of logic one has to be convinced that the economy is heading south and that we are witnessing the usual lead/lag relationship between growth and inflation.

Lets take another look at this inflation news for a moment and ask the question everyone assumes is not relevant: How much of our good inflation of the past decade is owed to disinflationary policies and how much to the pricing of goods and services determined outside the U.S. Counting angels on the head of a pin? Not really, because we are in an inflation targeting monetary policy and, if foreign influences dominate, which inflation are we curbing and how is it working? I understand the feedback effects, but lets just talk first order influences and leave the rest to graduate students searching for a thesis topic. Also, reading what most people write, there is alot of partial equilibrium analysis going on anyway.

So, in the 90s disinflationary monetary and fiscal policy. Budget discipline and a narrowing deficit with revenues fed, for the most part, by capital gains taxes. Monetary discipline, the spread between nominal GDP growth and Fed funds was exceptionally narrow throughout the period. Overseas? Weak oil, weak commodity prices, no real China influence (whatever happened to those Tigers?), all indicators of soft global growth.

Today, easy monetary and fiscal policies. Rest of world is growing, oil and commodity prices indicate that, as does the growth of China. Easy money? Ask any corporation or venture capitalist looking to raise funds and ask them. Are we sitting on a growing inflationary bubble that is being fed because the gdp/gdp potential gap is shrinking around the world?

Putting a disinflationary policy mix back in place in a "guns and butter" political climate is tough, so the Fed talks tougher than they are. Fed stops soon, because no one wants recession.

If there is a risk to current expectations (as evidenced in the market by people who place their bets rather than talk them) it is that the Fed keeps going because the economy keeps going. As I noted yesterday, if the CPI came in worse than expected, front end of the curve would steepen. The jun06/jun07 euro$ spread has steepend 7 basis points. That leads to what next? Of course there will be lots of talk about August and Sep in the coming weeks as new data arrive. To me, the real opportunities lie in the 07 contracts -- that is where the coming ease is priced in. Markets still want to believe the economy is grinding to halt due to tight money. In my humble opinion, the grind will occur but not yet.