What the Fed Is Up To

This past week Treasuries saw some serious selling after the FOMC minutes indicated that there was a substantial risk that inflation may not recede as expected and noted they must ensure it slows. The statement has about as much original content as notification that the sun rises in the East. Has the Fed ever said, "Inflation? No problem, don’t sweat it. We got it covered." In fact the Fed is merely putting the word out that unless inflation is contained to its satisfaction it may not lower rates as the market participants wanted/expected.

The underlying fact it that it is amazing that the Fed can exert so much power as it does not by changing rates but by taking an attitude to changing rates. Years ago the Fed "ran the economy" by adjusting money supply. That, intuitively, seemed real. Lower the money supply and less stuff get bought and inflation slows. But the Fed no longer has any meaningful control of the money supply. I have written about this before. Much of the money supply is outside the control of the Fed's reach over the banking system and the massive amount of credit availability through credit cards and HELOC’s creates buying power.

The Fed's ability to control the economy by regulating one interest rate on something that does not get used anyway (banks do not really borrow from the Fed window; they borrow from other banks) is impressive, The Fed, in effect, controls prime and interest rates up to 2 years. It is only the perception of the containment of inflation that keeps longer term rates in check.

Part of the reason why the Fed is so effective is that it is outside the control of politics or politicians. The forces which control what people say or do to get elected or reelected do not induce people to make wise fiscal choices. In fact, politicians have little to do with the ups and downs of the economy. They merely use them to take credit or ascribed blame to their opponents.

The market's present reaction to the Fed is yet another example of how players try to induce the Fed. Clearly it was the case that the amount of buying in the latest week-to-week bull cycle was based on a belief that the Fed would ease sooner rather than later. The FOMC simply said, "No, thank you. We are still concerned about inflation and, guess what, we control interest rates not you."

I do not believe that the Fed's words should to any great measure be construed as a warning that inflation is about to break out. The Fed is 1) being cautious and 2) serving warning that business must not allow CPI to move up if they want lower rates.

The pieces are in place for inflation containment: 1) lower energy prices 2) very high corporate profits allowing companies to absorb wholesale price increases and wage increase without passing the cost to CPI (the consumer) 3) flat housing prices will translate into less construction and lower costs for building materials and all that stuff that Home Depot sells.

Strangely, we see little concern about higher wages caused by a tightening labor market. To some extent this merely reflects the nature of the media. By classic standards we have such a low unemployment rate that we should be seeing wage inflation but just as in the 1990's wage increases remain modest. Contained wages are likely the result of 1) globalization and 2) weakened labor unions. The notions of nominal wage, real wage and employee compensation have been blurred by workers getting higher compensation in the form of the increased cost of medical benefits.

Comments

[xlr8shawn]

Glad you have this as one of your Catigories. I just saw a Documentary, Yes it is Long But Belive it is a Must see for EVERY RED Blooded American http://video.google.com/videoplay?docid=-1656880303867390173

Might Give some insite on what the Fed Res, Is doing