The Market's Frame of Mind
To the market's surprise the most recent Federal Open Market Committee statement didn't even hint at the threats implicit in the rise in commodity prices, especially oil, or the dollar's fall. These events have lowered the threat of deflation to virtually zero, but the Fed insists that deflation is still a slightly higher risk than inflation. Is the Fed keeping its head in the sand? Is Alan Greenspan bowing to George Bush and the upcoming election? Even before the Fed meeting, an increasing number of commentators insisted the Fed is too easy. Now such criticism has reached a crescendo.</br></br>On the surface, the censure seems justified. Commodity prices are rapidly increasing; the Commodity Research Bureau index of actively traded commodities is now at a level not seen since the inflation bubble of 1980. Oil stays stubbornly high, near $40 per barrel, and the Journal of Commerce Index of lightly processed commodities, once a favorite Greenspan indicator, has soared to an all-time high. And although the dollar has stabilized, it is down 25% against a basket of currencies since early 2002. Finally, the real Fed funds rate has been negative for two years and relative to real economic growth, the most negative since the inflationary '70s.</br></br>But there are good responses to these points. The rising commodity prices are due to China, which is churning out lower priced goods that keep inflation in check. The dollar has indeed dropped, but two years ago economists were saying it was too high. Today it's at, or just below, its purchasing power parity level, consistent with the persistent current account deficit. Furthermore, the smart money in the oil futures market says that the price is coming down sharply. And there is also a good response to the low real rates, a key variable in the critics' argument. Inflation hawks have maintained that by keeping the after-inflation cost of money negative, the Fed is feeding the fires of future inflation.</br></br>But if monetary policy were really too accommodating, wouldn't we see rising interest rates in the bond market? Yet with the 10-year bond yield under 4%, we see no such concern. Are those calling for higher rates saying that the bond vigilantes -- who have kept government and the Fed honest by pushing bond prices lower when the Fed's action has been inflationary -- are flat out wrong? That would be a sharp reversal from the past when the bond market was routinely praised for warning errant governments of monetary and fiscal profligacy.</br></br>With the 10-year indexed bond yielding a record-low 1.4%, a zero or even negative real Fed funds rate -- what we have now -- looks about right. If the Fed raised short-term rates, it would risk flattening or inverting the yield curve, something very dangerous early in a recovery.