What a Week: Drama Kings

At the intersection of the commodities rally and renewed inflation fears was Wednesday's news 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 inflation data came as a surprise to investors who had spent the bulk of the year adapting to the idea that the Fed would be on hold, and leaning toward becoming more dovish. Later Wednesday, investors found that the Fed's Open Market Committee had contemplated taking a more neutral stance at its January policy meeting, but ultimately decided against it.

With inflation now ticking up, commodities soaring and the subprime mortgage market imploding, the Fed's Goldilocks rhetoric seems out of date.

It's as if the Fed has two voices on each shoulder, one whispering: "You can't cut, there's too much liquidity and inflation is still above the comfort zone." The other whispers: "You can't hike, think about those poor subprime borrowers."

More apropos this week was Fed Vice Chairman Donald Kohn's words, warning of a liquidity crunch amid markets that are too complacent and spoiled by low volatility. "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 in a speech at the Exchequer Club in Washington, D.C.