Don't Expect Fed to Show Mercy With Inflation

Traders expecting a benign FOMC may be in for a nasty surprise.
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Wall Street participants will be polishing up their monocles and their magnifying glasses tonight ahead of Thursday's policy statement from the

Federal Open Market Committee

.

Traders were putting a shine on the stock market Wednesday afternoon in anticipation of a dovish statement, which may prove to be wishful thinking.

The wording of the FOMC statement is everything to a trader, particularly when the Fed has been on hold for a year during which the economy slowed well below the 3% trend and inflation has fallen. This time around, the market is focused on whether or not the Fed will retain the word "elevated" to describe inflation.

With hopes for a Fed rate resurgent after more fallout from the collapsed subprime mortgage market along with disappointing economics reports this week, traders could be in for a surprise -- if the Fed signals that it may be shifting its thinking on inflation from a focus on core inflation to one on headline inflation, which includes food and energy costs.

Odds of a fed funds rate cut by year-end have grown from zero to about 30% currently, amid the Treasury selloff earlier this month. The Treasury market also has rallied, leaving the 10-year note yielding 5.07% compared with 5.10% Tuesday and its recent peak around 5.30%.

Heading into the FOMC meeting, stocks enjoyed another reprieve from recent worries about struggling leveraged buyouts and a tightening of credit conditions in the mortgage-backed and other collateralized debt markets.

The

Nasdaq Composite

led the rebound, gaining 1.2% as

Oracle

(ORCL) - Get Report

posted strong earnings, gaining 2.8% on the day.

The

Dow Jones Industrial Average

added 0.7% to close at 13,427.73, while the

S&P 500

gained 0.9% to close at 1506.34. Blue-chip averages were led by renewed strength in energy stocks such as

Exxon Mobil

(XOM) - Get Report

as crude prices jumped $1.23 to $69 per barrel.

Brokerage stocks also were strong, as

Bear Stearns

(BSC)

, which has become the barometer of subprime anxiety, gained 2.8%, while

Goldman Sachs

(GS) - Get Report

rebounded from recent selling to climb 2.4%.

On Tuesday, the deal to finance the leveraged buyout of

Ahold's

(AHO)

U.S. Foodservice unit was canceled, as

reported here. But the underwriters of another highly leveraged buyout for

Dollar General

(DG) - Get Report

appear to be moving forward, according to S&P's Leveraged Commentary & Data unit.

While the high-yield market slid somewhat Wednesday amid the uncertainty, Dollar General's staying power suggests all is not lost for buyout deals in the high-yield bond market.

On Thursday, however, all eyes will be on the language of the FOMC statement. The sentence in question reads as follows in the May statement: "Core inflation remains somewhat elevated."

The Fed's favored measure of inflation, the core personal consumption expenditures index, is running at 2% on a year-over-year basis. Many believe that is the top end of the Fed's comfort zone. Analysts expect a 0.1% rise in the core PCE, putting the year-over-year pace at 1.9%. Core PCE is reported Friday, and it's unclear whether the Fed will have that data in hand at this week's meeting.

If the Fed takes out the word "elevated," thereby moving its assessment of inflation to neutral, Ben Bernanke will be confirming the market's suspicions about his inflation target. Investors will know exactly what Bernanke, who has stated he wants to move toward a more open inflation-targeting regime, means by the top end of the comfort zone. The market will know that next time the core moves to 2% or higher, the Fed will start worrying about inflation.

"If they drop elevated, we can pinpoint the upper band," says James Bianco, president of Bianco Research. "We will know the trigger point at which the Fed will start talking about hiking."

If the central bank leaves the word elevated in, the market may have to come to terms with the idea that the Fed may be shifting its gaze and its concerns to headline inflation, including recently rising energy and food prices, as opposed to just the core price measures, says Bianco.

Such a signal could spark a selloff in Treasuries, meaning higher interest rates and more trouble for the stock market.

As core inflation has fallen this year, overall inflation has been increasing. Overall inflation, as measured by the consumer price index, is running at 2.7%, while core CPI is down to 2.2%. Food inflation is running at 4% vs. a year ago as of May, according to the Labor Department, and energy is up 4.7%. Inflation in the service sector is also expected to remain elevated, and bouncing around 2.3% to 2.4%.

Amid expectations for a rebounding economy in the U.S. and strong global growth, demand for commodities and food is unlikely to wane. So as the market falls back on the familiar territory of rate-cut hopes to fuel a rebound, what many expect to be a mellow FOMC meeting could become the week's seminal event.

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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