Inflation, The Fed, and The Market: Where lies rationality?

7/17/06 8:14pm (Dow Jones) "Inflation is not the number-one threat to the US economy right now as much as the Fed's over-reaction to it," Merrill says. "The Fed's jawboning in recent months has been so intense that even with the turbulence in the markets, and the fact that two of every three economic indicators have come in below expected, that the futures market is still pricing in more than 50-50 probability that the Fed tightens yet again on 8 August," firm says. It's a "grim reality" that it probably comes down to Wednesday's June CPI number -- if it's 0.3% or higher month-over-month, the Fed has little choice but to tighten further, Merrill adds. (JHS)

Now that Merrill has said it, it must be true. Anyone who has been reading this blog knows that it has been my contention that the Fed will likely stop short of the number where money truly becomes expensive (6% or higher, based on nominal GDP growth) and keep some inflation bias in the system. The summation of what the Fed wants is a seamless turnover of the growth engine from housing to capital spending. No one, I repeat, NO ONE wants a recession.

Why the swap? Housing kept the economy going while business repaired balance sheets from the asset deflation that marked the past recession. Consumers didn't have to do as much since many more have homes as their number one asset as opposed to stocks. Capital spending improves the quality of growth over the long term. What helps spending today? Confidence in continued growth, weaker but not a collapsing dollar, cost of money below the expected return on physical capital to name a few.....and even a little inflation. Higher energy costs, as I have noted before, are also a boost to spending. In fact, now that everyone understands that $70 oil is here to stay and higher prices are likely, lots of opportunity for capital spending -- on the energy production and energy conservation sides of the broader equation.

Today we got industrial production and capacity utilization, this is from Bloomberg News as reported by Joe Richter

"Industrial production increased in the second quarter at an annual rate of 6.6 percent, the fastest since the final three months of 1997 and a sign corporate investment is sustaining growth as consumer spending slows. The inflation threat posed by higher energy costs and factories approaching production limits may prompt Fed policy makers to bump up interest rates again.

``Anything related to capital spending is strong and expected to stay strong,'' said Nariman Behravesh, chief economist at Global Insight Inc. in Lexington, Massachusetts. The rise in capacity utilization ``is one more indication that the Fed can't take its eye off of inflation. The Fed probably isn't finished raising rates.''"

Later in the article, Joe writes:

"Factories added 15,000 workers in June after shedding 8,000 in May, the Labor Department said July 7. The manufacturing workweek rose to 41.3 hours in June, the most since January 2000, from 41.2 hours in May.

A report from the Institute for Supply Management earlier this month showed that while manufacturing growth slowed in June, new orders rose to the highest in three months."

The swap is underway and so the Fed is writing and saying and looking for a place to stop and watch and wait. Markets have moved from certainty to uncertainty regarding the Fed in August. Thats okay, what still amazes is that EVERYONE assumes that the Fed will be easing next year (how else would you get the inverted curve from 2s to 5s).

Interestingly, if you play around with the Sep/Oct futures spread and its reaction to various events it could hedge up your downside risk in any Treasury -- even 30 year Zeros. Imagine that, if you run a pension fund you can buy an asset at 23 that is guaranteed to go to 100 in 30 years (400% return over 30 years?) with no downside risk with a costless hedge. Everyone still matching pension liabilities with equities?