Monetary policy, while de-emphasized in the minutes of the May 10 FOMC meeting, works with a lag, the Fed has repeatedly said. But monetary policy may also lag the action in commodities prices, which resumed their recent downtrend Thursday.

The price of metals such as copper, gold and silver

fell sharply as investors took profits in the steady fizzle of risk appetite. Copper was hit hardest in the metal commodities markets, falling 4% to $3.47 after a 7.7% decline triggered a midmorning trading halt on Nymex. Gold fell 2.4% to $633.50 per ounce, while silver fell 4.4% to $11.90.

Since reaching an all-time high above $4 a pound in early May, copper has dropped 15%. Gold, which reached a 26-year high of $730 last month, is also down 15% from its peak, and silver has dropped 17%.

Against that backdrop, the Fed's search for the delicate balance of fighting for credibility while trying not to deliver a knockout punch to the economy may be further out of reach than anyone knew. Speaking of balance, or lack thereof, Thursday's data painted a decidedly mixed picture of inflation and growth.

Housing data showed the residential real estate market is still slowing, but consumers were resilient as retailers such as

Target

(TGT) - Get Report

and

J.C. Penney

(JCP) - Get Report

posted strong May sales.

U.S. manufacturing growth mellowed in May, but the prices paid component of the Institute for Supply Management's report points to inflationary pressures. Then again, productivity for the first quarter was revised up while unit labor costs were revised down, suggesting milder inflation pressure coming from the labor market. All of this emerged while the markets were still digesting the hawkish May FOMC minutes released

Wednesday.

"What is going to end up dominating is the FOMC minutes," says Anne Briglia, senior fixed-income strategist at UBS. "There was a real departure there this time.

The Fed's considering a 50-basis point hike shows there is probably less consensus now that at any point in the cycle."

Despite such concerns, stocks ramped up in the last half hour of trading to close at their highs of the day for the second straight session. The

Dow Jones Industrial Average

closed up 0.8% to 11260.28, while the

S&P 500

gained 1.2% to close at 1285.71; the

Nasdaq Composite

rose 1.9% to close at 2219.86.

In addition to retailers, major averages were led by tech and telecom stocks such as

Juniper Networks

(JNPR) - Get Report

,

Cisco

(CSCO) - Get Report

and

Qwest

(Q)

.

The Treasury bond-yield curve flattened a bit, demonstrating the market's expectation for slower economic growth. The dollar was mixed, falling 0.16% to 112.65 yen while the euro fell 0.08% to $1.2802.

A Lagging Indicator

One might have believed that Thursday's falling commodities prices would temper the inflation outlook. The Fed itself has remarked on how little commodities prices have passed through to core inflation. But core inflation may be lagging the precipitous rise in nonenergy commodities prices more than it lags monetary policy. The core inflation creep, reflected thus far by two higher-than expected core CPI reports, is just the beginning, says James Paulsen, chief investment strategist at Wells Capital Management. And the historical precedent is right under our noses.

Nonenergy commodities prices spiked in 2003. Sure enough, about one year later, core CPI went from 1.1% in January 2004 to 2.4% in 2005. Commodity prices started spiking in August last year, and now almost nine months later, CPI is creeping up, he says.

"Last time around nobody noticed" because 1.1% inflation had markets fearing deflation. A jump in the core CPI was considered a good thing, says Paulsen. "The next round will be more noticeable."

This time the base is 2.3% for core CPI, not 1.1%, and it is going to 3% or 3.5%, he says. This will hurt a lot more given that the U.S. has higher rates, highly levered consumers, and a tight labor market. People may demand higher wages, which could eat into corporate profitability, and the bond market could take 10-year yields to 6% vs. the current level of 5.10%. Last time, bonds took rates to 4%, but that was still relatively low.

All is not lost, however. A competitive global marketplace for resources will help keep inflation from running away to 1970s levels, says Paulsen. In the long run, average inflation may wind up closer to 2% over the next several years, he says.

"We do have to get used to 2% to 3% inflation," says John Lonski, chief economist at Moody's Investors Service. But the Fed would never acknowledge anything of the sort. Changing the target range for inflation would anger the world too much because higher inflation drives down the value of their U.S. assets, Lonski says.

Perhaps the Fed just can't control inflation as much as it used to, given the global economy and demand for raw materials by China and India, says Marc Pado, U.S. market strategist at Cantor Fitzgerald. If China's economy slows, it slows from 10% and would still show strong demand for commodities and energy.

"If you resign yourself to the fact that you don't have control over inflation, then you have to take a different tack," says Pado. "The best we can do is to grow the economy at a pace sufficient to absorb inflationary pressures."

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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