Eighteen months ago, I accused the Fed of manipulating inflation data as well as constructing a deflation hoax. With hindsight, it appears that both accusations were correct. I also anticipated a rocky outcome when the Fed normalized unsustainably low interest rates. The consequence of that maneuver remains to be seen, but the outlook depends on the Fed's next move.

I can only fathom a guess as to why Fed officials manufactured that scare: In order to keep the economy cooking through his scheduled retirement, the Fed chairman required a not insignificant dose of artificial stimulus. Well aware of the wealth effect, especially from real estate appreciation, Greenspan initiated a bull market in property with artificially low interest rates. The deflation scare was just a ruse to camouflage his true stimulative intentions.

However, my column highlighted the obvious inflation risk last spring. Commodity prices were starting to advance. Service prices such as education, insurance, entertainment and health care premiums were rising rapidly. Real estate prices were soaring. The only real deflation out there was from Wal-Mart-purchased, Chinese-manufactured widgets. The only problem is this is a service economy and those expenditures were immune to Chinese competition -- and retail widgets are a small part of the economy anyway.

We all know what has happened to the headline CPI since, even with the hedonic adjustments.

Just as I disagreed with the Fed party line then, I dispute the inflation story today. It's funny how I disagree so often with the Fed's positions. It bought the New Economy silliness, I didn't. I foresaw rapidly building inflation pressures, they deflation risks. And now, as Fed governors incessantly highlight the perils of escalating prices, I perceive inflation risks as mitigating. The risk to the economy today is not runaway prices, but rather Fed Reserve vices. That's correct. The danger to this economy right now is the Fed's annoying, undesirable tendencies to push rate hikes much too far.

But wait a minute. With spiking commodity prices, low unemployment and rising capacity utilization rates, how can I be so sanguine regarding inflation? Don't I see the reported CPI and PPI data? Surely I of all people cannot buy that "core inflation" nonsense.

I do see the headline numbers. And we most certainly did experience a meaningful bout of inflation. However, the BLS mitigated its true scope with hedonic adjustments, unreal CPI component weightings, and nonsensical substitutions (the largest being owner's equivalent rent). In a perverse way, the "management" of the CPI kept the true pricing pressures out of inflation expectations and unit labor costs. Well, that and the outsourcing risk to the American work force.

From "One Percent Wonder" to Five Percent Blunder?

The Fed's inflation rhetoric today is just as misguided as its deflation expressions last year. Only nascent, disinflation pressures are visible:
  • The real estate bull market is history.
  • New capacity and demand destruction are bringing commodity prices back into balance.
  • Many service prices are flattening after large increases.
  • Even the government appears to be getting serious about health care costs.
While not obvious today, I can envision a legitimate 2%-3% headline inflation rate over the next 24-36 months.

But if the Fed does not throttle back its rate hikes, it risks throwing the entire economy into a premature recession. I can accept the Fed's jawboning as an attempt to raise risk premiums in the financial markets; investors had become too complacent in this respect.

However, serious restrictive forces are already at work in the economy today. They just need time to work through the system. One year from now consumption will be lower, savings higher and the impact from higher energy prices and interest rates will be present. Why not pause for a period to measure the impact of these forces on the economy before stringing together another round of rate hikes? The Fed has already successfully engineered a midcycle pause. Why jeopardize it?

The Fed should not risk the recovery with an interest rate "rebalancing" effort that smacks the financial markets and the real economy over the head. Quite simply, it screwed up taking rates to 1%. It should not botch, bungle or flub normalizing short rates. Sometime the hardest thing to do is nothing. We need a big dose of nothing from the Fed for the next year.

What does this mean for equities? Should the Fed signal an end to the rate hikes, stocks will rally. Economically sensitive shares -- many down quite a bit from their highs -- should rally the most. I prefer selective positions in many "chicken cyclical" sectors including industrials, raw materials, technology, retail and financials. In my next column, I will share some more individual names that should benefit from a rate-pause-induced rally.

Alan, do investors, employees and homeowners a big favor. Don't go out with a bang, but rather, with a whimper.
Robert Marcin is the founder of Defiance Asset Management, a private investment management firm. Client accounts managed by Defiance Asset Management often buy and sell securities that are the subject of writings by Marcin, both before and after the writings are posted. Under no circumstances does this column represent a recommendation to buy or sell stocks. This column is intended to provide insight into the financial services industry and is not a solicitation of any kind. Neither Marcin nor Defiance Asset Management can provide investment advice or respond to individual requests for recommendations. However, Marcin appreciates your feedback; click here to send him an email. Marcin is not required to update or held responsible for updating any portion of this column in response to events that may transpire subsequent to its original publication date.