Inflation puts Fed in the hot seat

Markets predict tighter monetary policy

Big week. Bottom line: the Fed has an inflation problem, and markets are beginning to adjust – beginning – to how high and tight the Fed may have to pitch. Mortgage rates have held 6 percent, but barely, and probably temporarily.

Bonds ignored the terror alert in New York, ignored the bird flu flap, but did react to economic data, for the most part a lot of pointless lurching at post-Katrina garble. Last Monday, the purchasing managers' manufacturing index for September soared to 59.4 from 52 in August, and the bond market fell apart in an instant. Bonds revived the next morning on news that the manager's service-sector index had crashed to 53.3 post-Katrina from 65 in August.

The durable and damaging residual from the purchasing managers' whipsaw: the prices-paid component of the surveys went off-chart in September: roughly 80 percent of purchasing managers paid higher prices for everything, not just energy products.

Friday morning's coulda-been-worse September job report blew up bonds until traders realized the data didn't include all the Katrina job losses. However, strong revisions in July and August jobs confirmed that the pre-Katrina economy was much stronger than thought, largely unharmed by energy prices and the Fed.

To understand inflation, make friends with somebody old. No one under 45 has a business memory of an energy-driven inflation episode. The central error that kids are making today is to believe that rising prices will slow the economy. The lesson of the '70s: early-stage inflation stimulates the economy. Widely rising prices make the economy run hot – until the Fed removes the money necessary to pay them.

The Fed probably has a long way to go from today's 3.75 percent to pre-empt inflation; on the low side of proper estimates, 4.5 percent by Fed Chairman Alan Greenspan's last meeting on Jan. 31. The crucial 2s-to-10s Treasury spread is still within .2 percent, indicating that the market expects/hopes that the Fed will be tough enough, soon enough.

Read the entire Lou Barnes Inman News article at Citywide Services