Bulls Hack Out of a Thicket

The more closely watched consumer price index comes out Friday morning, but traders are expecting a steep reading because of Thursday's producer price index results. The core PPI rose 0.4% in February vs. expectations for a 0.2% reading and after last month's 0.2% rise.

Headline producer prices rose 1.3% against analysts' expectations for a 0.5% increase. The jump in headline inflation was due mostly to higher energy and food prices, and traders believe the same will be true for consumer prices.

"A benign CPI reading could ease people's fears," says Diamond.

Indeed, the Federal Reserve, which has left the fed funds rate unchanged at 5.25% since last August, is oddly facing a bit of a deja vu situation. Last spring, the markets sold off amid fears of a liquidity crisis while inflation crept up and the Fed got closer to pausing. Sounds familiar, but this time around, the Fed may be getting closer to cutting rates, and there is more at stake in playing that hand.

"Traders are aware the Fed has nothing up its sleeves," says Diamond.

Pausing doesn't inject liquidity into the market, while cutting rates does. If the Fed cuts rates to "rescue" a downward spiral in the residential real estate market (something former Fed chief Alan Greenspan warned of Thursday), the results could lead to much bigger problems and even higher rates in 2008, says John Lonski, chief economist at Moody's Investors Service.