Inflation Jitters at Fever Pitch

With the Ben Bernanke-led Fed having declared itself to be "data dependent," the inflation reports take on greater-than-normal importance for traders.

But "these are tortured data," says Jeffrey Saut, chief investment strategist at Raymond James & Associates, suggesting that the PPI and CPI data don't adequately report the higher cost of goods. "What they are telling you just doesn't jive with what you see in real life," he says.

According to data from the U.S. Department of Labor Bureau of Labor Statistics, for the 12 months ended at the close of February, energy costs rose 20.1%, transportation rose 5.8%, food rose 2.8%, and medical care rose 4%.

February's 0.7% increase in the CPI points to an 8.4% inflation rate on an annualized basis, notes Saut. If the March CPI inflation comes in is as expected, at 0.4%, that brings the annualized rate to 6.6%. With the fed funds rate at 4.75%, that means we are still in a negative "real" interest rate environment, he continues. "Given the possibility of still 'free money,' no wonder speculation remains rampant in the various markets."

Indeed, prices of so-called speculative-asset classes are near record highs. For example, risk premiums on high-yield bonds are 339 basis points over 10-year Treasuries as of Monday. At the end of 2004, the asset class saw risk premiums 310 and 313 basis points over Treasuries. The all-time low was in September 1997, when spreads hit 274 over Treasuries. Currently, the average price of high-yield debt is 98.3 cents on the dollar, meaning investors are not being paid much to take the risk of owning these so-called junk bonds.

The Fed is expected to raise its base borrowing rate to 5% at the next meeting of the FOMC on May 10. Whether or not it will continue beyond May 10 is anyone's guess, including presumably well-placed members of the financial press. Recent conflicting comments from various Fed speakers reveal internal dissension in the central bank. That the debate is happening in public is a reflection of Bernanke's desire for a more "transparent" Fed. But it also reflects the fact (which is dawning on more traders by the day) that the Fed itself does not yet know when it will stop tightening.