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Fed Faces Credibility Crunch

Liz Rappaport

After the Labor Department reported a surprising jump in core inflation Wednesday morning, the afternoon revelations that the FOMC discussed using more dovish language at its January policy meeting felt like reading last week's newspaper.

It turns out many investors were not so wrong last month to believe that the Federal Reserve would remove its tightening bias at the January FOMC meeting. The minutes released Wednesday reveal that the members debated such a possibility.

But the moment for dovish rhetoric was fleeting, as the consumer price index data and a commodities rally suggest the inflation dragon is nowhere near slain. Rising inflation amid slower growth puts the Fed and Chairman Ben Bernanke in a most-loathsome pickle -- how to retain credibility without killing the economy.

"The members discussed whether the balance of risks language in its recent statements still was the best way to represent the views of the committee," read the FOMC minutes.

The committee's views are summed up by one sentence in the document:

"The economic information received since the last meeting pointed to a somewhat more favorable outlook regarding both inflation and economic growth than they had earlier anticipated."

But that meeting came before lackluster January retail sales, soft nonfarm payrolls, a jump in jobless claims, weak industrial production and a below-50 reading on the Institute for Supply Management's manufacturing index. But, growth can dampen a bit and remain near-trend and within the parameters of the Fed's forecast.

What was startling surely to the Fed and to the markets was January's inflation reading. The Labor Department reported that core CPI rose 0.3% in January, ticking up to 2.7% year over year from 2.6% in December. Headline CPI rose 0.2%.

The stock market was disappointed with the data, as the Dow Jones Industrial Average and the S&P 500 took a breather from their weeklong winning streaks, both weighed down by the sell-the-news reaction reaction to Hewlett-Packard's (HPQ Quote) earnings report Tuesday evening.

The Nasdaq Composite bucked the trend, rising to a new high for the year, up 0.2% to close at 2518.42. The Dow Jones Transportation Average and the Russell 2000 also bucked the broad market trend, rising to new all-time highs. The DJIA fell 0.4% to close at 12,738.41, while the S&P 500 slipped 0.1% to close at 1457.63.

The transports rallied despite oil prices closing above $60 per barrel for the first time in 2007. More-than-1% gains in image-damaged JetBlue Airways(JBLU Quote), trucking outfits Con-Way(CNW Quote) and YRC Worldwide(YRCW Quote), and railroad Union Pacific(UNP Quote) led the transports' advance.

So even as the January minutes show the Fed is close to a neutral policy stance, the central bank is now perhaps just as close to a credibility crunch. That's if inflation were to tick up toward 3% year over year, says James Paulsen, chief investment strategist at Wells Capital Management.

"Ever since Bernanke came to the chairmanship, the Fed has said that 2% or lower is their comfort zone, and they've acknowledged it is above the comfort zone, but they've said it would peak as the economy slowed," says Paulsen. "Well it's still above 2%, and it didn't peak. It went back up."

While many, including the Fed, have noted that oil prices could be the volatile commodity that impacts inflation, the real story is in the other raw materials, says Paulsen. Investors took note today, as commodities indices that exclude energy are at or a hair short of new all-time highs -- including the Journal of Commerce Raw Industrial Commodity Price Index, the Goldman Sachs Commodity Index ex-energy, and the CRB Raw Industrial Index.

Gold soared $23 Wednesday to $684 per ounce, while gold-based exchange-traded funds like streetTracks Gold Shares (GLD Quote) and iShares Comex Gold Trust(IAU Quote) gained 3% on the day.

IDEAglobal's chief economist Joe Brusuelas believes that inflation will remain "sticky" and bring higher readings for the next few months as home rental prices remain high. But more supply will come onto the rental market as developers shift unsold units to rental units, which he believes eventually will bring rental prices and core inflation back down. Brusuelas says this puts the Fed on hold for the remainder of the year. Next week brings the January reading of the Fed's preferred inflation measure -- core personal consumption expenditures. As of December, core PCE is running at 2.2% year over year.

As I said in a speech Tuesday night at a gathering of the Society for the Investigation of Recurring Events, or SIRE, there was too much liquidity in the world to suggest the Fed would cut rates even before Wednesday's CPI report. Junk-bond spreads are near all-time lows hit in 1997. M&A activity is running at 47% more by volume than it was in the same period of 2006. Risk appetite and animal spirits are alive and well in the markets.

That's why investors should perhaps have paid more attention to Fed Vice Chairman Donald Kohn's comments Wednesday in a speech at the Exchequer Club in Washington, D.C. Kohn warned of too much complacency in financial markets amid low interest rates and ample liquidity. Evidence of such complacency came Wednesday in markets' minimal reaction to the Bank of Japan's rate hike.

"In such a world, it would be imprudent to rule out sharp movements in asset prices and deterioration in market liquidity that would test the resiliency of market infrastructure and financial institutions," said Kohn. As a Greenspan confidante, Kohn's words may be more telling than the surface remarks reveal. Is he talking about the carry trade or the subprime housing market, which was roiled again Wednesday by NovaStar Financial (NFI Quote), or both?