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The First REAL Conflict for Bernanke


...politicians/bureaucrats are usually the LAST to embrace a trend that has long been in place.

Last week's testimony from Bernanke can rightly be considered hawkish: signaling that the economy may have greater risks of overheating than contracting was of paramount importance, as was his admonition of higher energy prices and potential "pass through" risks. Add to this the real political exigencies of appearing to be forthright in upholding the Greenspan legacy of "fighting inflation" (even though the facts utterly belie that perception), and you have the path to a 5% handle on the fed funds rate at a high probability. Indeed, it is swiftly becoming the whisper number for fed funds over the next few meetings: Fed Funds futures show a nearly 100% probability of 4.75% by April.

And here's why the current posturing by Bernanke could create the first REAL conflict for this Fed Chairman.

While the inflation picture from a traditional perspective – wages - has been muted at best, inflation ("speculation") HAS been present in anything that can be packaged and quoted as a financial contract, traded with liquidity, and settled in a back office somewhere in dollars. Thus all that high powered reflation post 2001 has already clearly made its way into the economy, just not in the traditional way that the Fed's models expect: it has not gone into the traditional economy but has leaked – gushed really – into the financial economy. Thus, anything that could be quoted, bought and sold easily with leverage was. And those commodities had huge runs from 2001 to present. And this financial economy/real economy dichotomy explains very nicely the reason why we have NOT seen much pass-thru into CPI from massive commodity price increases. An analysis of crude, intermediate, and finished goods PPI shows this dynamic nicely.

Too, of course, real estate was a bucket into which this liquidity flowed. After all, homes and condos benefited in no small way from the adage above: "anything that could be quoted, bought and sold easily with leverage was." Thus we had massive increases in housing prices, housing demand, mortgage demand (and related exotica), and various derivative industries (construction, services, etc.)

But here is the rub, and thus the difficulty that is likely to be self-imposed by Mr. Bernanke's recent hawkish testimony. Natural gas is down 54% from its Nov peak. Oil is down 13% from August's peak and unleaded gas is down 51% from its post Katrina peak. And housing prices, which one year ago were up 17% y/y, are now up a mere 3-4% depending on the measure one uses. Save for crude oil, those measures classify as massive declines in such a short period of time. And they represent deflation.

We have written before about how politicians/bureaucrats are usually the LAST to embrace a trend that has long been in place. The idea that the Fed is NOW so concerned with inflation, when inflation of assets has been such a dominant and obvious trend, is yet another sad example of this very human tendency. In 2000 the Fed did very much the same thing: worried (very publicly I might add) about inflation when the greatest deflation since the great depression was immediately around the corner. Thus, the press release accompanying the May 16th 2000 50 bps increase in Fed Funds target said:

"The Federal Open Market Committee voted today to raise its target for the federal funds rate by 50 basis points to 6-1/2 percent. In a related action, the Board of Governors approved a 50 basis point increase in the discount rate to 6 percent.

Increases in demand have remained in excess of even the rapid pace of productivity-driven gains in potential supply, exerting continued pressure on resources. The Committee is concerned that this disparity in the growth of demand and potential supply will continue, which could foster inflationary imbalances that would undermine the economy's outstanding performance.

Against the background of its long-term goals of price stability and sustainable economic growth and of the information already available, the Committee believes the risks are weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future.

CPI went from 3.6% y/y to 1.1% 2 years later. PPI went from +4.4% to negative 2.9% over the same time frame. And you already know what happened to asset inflation. It went from positive to very, very negative. One might say assets even deflated.

Thus, it should prove to be quite a spectacle to watch as a newly hawkish, politically sensitive Fed Chairman with big inflation fighting shoes to fill acts when faced with increasing evidence that BOTH the real economy and the financial economy are increasingly experiencing deflation when they are all armored up to fight the last, and already abandoned, battle of inflation. Next week's housing data will be interesting to watch.

"Just then they came in sight of thirty or forty windmills that rise from that plain. And no sooner did Don Quixote see them that he said to his squire, "Fortune is guiding our affairs better than we ourselves could have wished. Do you see over yonder, friend Sancho, thirty or forty hulking giants? I intend to do battle with them and slay them. With their spoils we shall begin to be rich for this is a righteous war and the removal of so foul a brood from off the face of the earth is a service God will bless." Cervantes' Don Quixote.
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