Thursday, July 06, 2006

Thursday Open -- The Only Thing We Have Inflated is Inflation Itself!

While yesterday's trading (and probably today and tomorrow as well) was all about job creation, the markets really only care because the Fed cares. And the Fed really only cares because job creation causes inflation, right?

Not really. Most economists dismissed the idea of a Phillips Curve back in the 1980's, after witnessing the stagflation of the 1970's. If more jobs equals more inflation, how could you ever have stagflation?

Conversely, look back at recent speeches by Fed officials and look at how often they use the phrase "elevated inflation expectations" or some such. Look at yesterday's Wall Street Journal online poll, which had 73% of voters either somewhat or very worried about inflation. Look at gas prices, which is probably the only goods price that consumers can actually observe changing from day to day, and is therefore the dominant factor in how the average Joe views inflation. Inflation expectations are certainly elevated.

As I wrote yesterday, Fed economists seem to favor the rational expectations theory of inflation. This means that if expectations are elevated today, actual inflation is likely to be elevated tomorrow. The only way the Fed can fight rising expectations is by credibly pledging to prevent any significant acceleration of inflation through monetary policy. They will keep hiking until the market and the broader economy gets it. If that means a recession in 2007 or 2008, so be it. Once a central bank's credibility is gone, it takes a long time to come back. Ask Japan, they'll tell you.

Getting back to job creation, as long as job growth is strong, the Fed knows it has plenty of room to keep hiking and not cause any actual pain. In other words, under their dual mandate, they can literally ignore the employment half and focus on the inflation half.

Ultimately this is all bond bullish and stock bearish, but an entry point into bonds is going to be tricky to find. I'd like to say 10yr at 5.50%, but I can't say there won't be more pain after that.

1 comment:

Accrued Interest said...

I agree with you, Jay, about the ultimate effect of gas prices. My point is this: if you ask a random person on the street about their inflation expectations, what are they basing it on? The fact that milk is up 7 cents this year or the fact that gas is up $1?