Fed's MO: Tough (but empty) Talk

Macro Perspectives

We closed last week with a hot May inflation report.

Despite what the Fed, the politicians, the media and Wall Street wanted us to believe, inflation has not peaked.

In fact, not only was the year-over-year 8.6% rise in prices a new forty-year high, the really big number was the monthly change. In a month where prices were expected to cool, the change in the consumer price index from April to May was 1% - annualise that we get 12.7% inflation.

As we've discussed here in my daily notes, in the 1973-74 and early 80s inflation spikes, the Fed had to ratchet rates above the rate of inflation to finally get it under control.

With this in mind, the markets are expecting some reaction to the inflation data by the Fed. Conveniently, they meet this week on rates, where the expectation is that they will raise another 50 basis points (the second 1/2 point hike in six weeks). But we shouldn't expect anything more from the Fed, than delivering on what was promised (50bps and gradual balance sheet reduction), and some more tough (but empty) talk.

Remember, for the reasons we've discussed about sovereign debt vulnerabilities (domestic and global), a 70s and 80s-style inflation fight isn't in the cards. Instead of double-digit interest rates, the Fed has opted to attack inflation by attacking demand (jobs, wages and the net worth effect from a lower stock market).

That has been working; household net worth has fallen for the first time in two years, confidence in May hit a record low.

The problem: The largest contributors to the inflation numbers this morning were shelter, gas and food. These are supply related (even housing), mostly related to the policy attack on fossil fuels, and the subsequent structural supply deficit.

Again, this is the stagflation, lower standard of living formula.

The notable movers on Friday: stocks lower, sovereign bond yields higher (including another jump in European yields), and gold higher.

On a final note, we've talked about the vulnerabilities in Europe to another sovereign debt crisis, following last week's ECB announcement that they will be ending QE in July (QE=the lifeline to the Eurozone government bond market). A sovereign debt crisis would threaten the existence of the euro (as it did in 2012).

This chart of the euro seems to be communicating that risk.

NB: the lighter, shorter, blue support line was highlighted in a previous note. $EURUSD has depreciated ~5% since that “trendline break”.