Can You Hear Me Now? What?

John Berry says markets are misinterpreting the Fed's recent miscommunications:

Fed Doesn't See Any New Inflationary 'Monster', by John M. Berry, Bloomberg: Like a youngster unable to sleep because he thinks there are horrible monsters hiding in his closet, financial markets have been spooked by irrational fears of surging inflation. The result: an imagined need for endless interest rate increases to bring prices under control.

Yikes! Inflation!

One eye on inflation the
other eye on ... hey wait!
I don't have another eye.

Every time a Federal Reserve official says that U.S. inflation in recent months is outside the ''comfort zone,'' investors sell assets on the grounds rates are headed higher, perhaps much higher.

The investors ignore the fact that the officials also say pointedly that they expect economic growth to slow and inflation to subside later this year. None of the officials, from Fed Chairman Ben S. Bernanke on down, have indicated they believe a new inflationary spiral has begun.

To the contrary, many of them have explicitly said the opposite. The whole fuss started when Bernanke said in congressional testimony ... that the Federal Open Market Committee might let a meeting go by without raising rates -- even if inflation remained elevated -- to wait for more data...

That was seen by many analysts and investors as a sign Bernanke and the Fed had turned soft on inflation. Since then every Fed speaker ... has been careful to stress the need to keep inflation low.

All those statements have improved the Fed's inflation fighting reputation. Unfortunately they also seem to have convinced many people that inflation is worse than anyone thought, and that the Fed is going to have to raise rates a lot.

For example, on June 12, Sandra Pianalto, president of the Cleveland Federal Reserve Bank, said ... that core consumer prices have increased ''at an annualized rate of more than 3 percent during the past three months. This inflation picture, if sustained, exceeds my comfort level.''

That part of Pianalto's remarks was one reason cited for a sharp drop in stock prices that day. Few paid much attention to other parts of her speech that suggested strongly that she expects inflation to ease without much more action by the Fed. The current Fed target of 5 percent for the overnight lending rate is ''near a point that is consistent with a gradual improvement in the inflation outlook,'' Pianalto said. ...

Certainly such words, which are in the same vein as most other public comments by Fed officials, wouldn't be uttered by someone who felt the country faces a deeply embedded inflation that will take a large scale policy response to root out. Yet that is how markets seem to be interpreting what officials are saying about inflation and the prospects for interest rates. ...

Now the markets overwhelmingly expect the FOMC to raise its overnight lending rate target to 5.25 percent on June 29. There also seems to be a growing expectation that economic growth is going to slow, perhaps a lot. At least that is the reason being cited for the ongoing plunge in some commodity prices, particularly for copper, gold and other metals, none of which is consistent with an inflationary spiral...

Suppose that the markets overwhelmingly expect an increase in the target rate to 5.25% as they do now, and, though there is disagreement and nobody on the FOMC believes 5.25% would be a disaster, the majority believe optimal policy is to leave rates at 5.00%.

In that situation, would the Fed have the will to go against market expectations, particularly with the credibility of a new chair on the line? I don't think they would surprise the market, at least not at the next meeting. So even if the majority believe a pause is best, if market expectations do not support that move and the Fed does not move expectations in that direction before the meeting, I don't believe they would go against the market.

So, I think two things work against a pause even if the Fed desires to do so. First, without very clear evidence of inflation easing, and who knows what the next price report might bring, I doubt they are willing to whipsaw expectations once again. Since there is uncertainty over whether 5.00% or 5.25% is optimal anyway, there's no sense upsetting the markets yet again unless the evidence is very clear. Second, if expectations are overwhelmingly for 5.25%, I don't think the Fed will be willing to surprise markets and pause anyway.