The Fed's Inflation Fear, Foretold

The Federal Open Market Committee kept the bond market intact this week with some linguistic legerdemain, vowing to hold interest rates down for a "considerable period" while quietly signaling that inflation had moved up on its enemies list.

Attentive Fed-watchers could see it coming.

"The probability of an unwelcome fall in inflation has diminished and now appears roughly equal to a rise in inflation," the FOMC opined Tuesday, while leaving its target interest rate at a 45-year low. With every asset market in the country keying on the "considerable period" language, this stealth tweak got a potentially risky job done.

In the past, any time the Fed de-emphasized disinflation, it has thrown the bond market into fits. This time around, after a reflex selloff, bonds held their own, with yields on the five- and 10-year notes actually falling slightly Wednesday. Heavy selling of yen by the Japanese central bank also helped drive demand for the bonds, as many traders expect it to use its dollar proceeds to buy Treasury notes.

That the Fed was inclined to tweak the inflation zeitgeist should've been apparent to those with their eye on the right data sets: metals commodity prices and U.S. manufacturing activity. Among all the favored indicators, these are among the most accurate in divining Fed policy.

The Industrial Metals Price Index measures the price of commodities used in global manufacturing such as aluminum, copper and zinc. Over the past 20 years, the index has risen sharply three times, and on each occasion the Fed has raised interest rates.

"Industrial metals price inflation is an indicator of manufacturing growth," said John Lonski, managing director and chief economist at Moody's Investors Service. "The current upsurge is the fourth major upsurge since the early 1980s, the other instances being in 1987-88, 1994 and 1999-2000. In each instance, the Fed tightened." Without Fed action, metals prices will probably continue to rise.