The Fed wants it both ways...wants the flexibility to respond to incoming
data but does not want any of the key tier one data reports to make or break a rate decision. Blame uncertainty, blame contra-signals, blame fickle markets and any other excuse you can come up with. But the fact is that policy making at inflexion points in the business and interest rate cycle is never easy and nothing new for markets or the Fed. The problem with the Bernanke Fed is that we are told policy will be made less on a Greenspan ad-hoc basis and closer to a predictable, rules basis (forecast for growth and inflation). This was best outlined by Bernanke in the JEC testimony and echoed in public remarks by Yellen.

But that was before the Fed became concerned about its image and seems to have lost its focus. Te Greenspan imprint of micro managing the economy and market expectations (asset prices) is a game that some at the Fed find irresistible if not justifiable. The minutes of the May 10 meeting seemed to be more message than reflection of the entire realm of thinking at the FOMC. They cut but did not paste concerns about overshooting, may yet language nor the headwind from sticky upward energy prices. The seemed tailored to the market and press amplified inflation credential problem created by Bernanke's pause presentation to the JEC.

Essentially markets do not know what to make of the Fed, and moreover how much sway Bernanke holds over the FOMC. It is safe to assume a lot less than Greenspan, and much of this is deliberate. But this is also starting to look like the inmates, the FOMC members, are running the penitentiary and not the warden. In some respects it is a refreshing change from the heavily centralized Greenspan Fed. I like knowing what Moskow thinks on inflation and associated risks even if it is not exactly the same pitch Bernanke is singing in. However, markets are like pets...they learn things one way and have trouble unlearning much less relearning. So a bit of a perfect storm of uncertainty at the inflexion point in the business cycle and rate cycle, a new and different Fed Chairman, end of a lengthy period of great certainty in rates and economic outlook and revelation that there is more than one stream of thinking at the FOMC and all voices count.

Bottom line for me is that as much as Bernanke seems to be pulled into a
Greenspan-like dance with the markets (expectations) he will step back and stick to making policy off the forecast and adjust the forecast based on incoming data and that means more than March and April core CPI at 0.3% m/m and core PCE at 2.1% in April. Even Moskow stressed on Friday that the Fed does not respond to one piece of data including employment and inflation reports. I suspect the case for a rate hike June29 is still quite strong based on inflation expectations...the inflation drift upward in core CPI is] in the forecast, not forcing a rethink. Thursday's ISM and recent housing, plus the May jobs data, have all reined in inflation expectations and arguably a 17th rate hike offers little downside risk and would cement Bernanke's credentials more solidly with the financial markets. Are we to believe that 5.00% there is a perfect landing and at 5.25% a hard landing? Moreover, I said earlier this week that focusing on one more rate hike from the Fed before a pause for building a long dollar trade is risky and a form of tunnel vision. The weak dollar trade is early in its lifespan even as the Fed contemplates one more rate hike in the cycle, maybe even two. However, the Fed is not ready to pass neutral and move to a restrictive cycle of tightening ahead.

I almost forgot to mention the ECB where a half point rate hike remains a distinct possibility (say 40%) June08. The ECB is well behind where it
wants to be on normalizing rates and so any discussion of a half point hike
at the ECB is far more meaningful than what was presented in the May10 FOMC minutes as Fed took up the question of 50bps (think this is more Bernanke's open-mindedness at work than simply any strong draw or single FOMC member seriously arguing for 50bps). And by no means should we rule out a July rate hike by the BoJ...Fukui was ultra aggressive in ending quantitative easing, though ending ZIRP is far more radioactive politically.

What the Fed's one or two more rate hikes will do for the dollar is help
keep the decline orderly. But my recommendation for Bernanke is stay clear of getting sucked into image building behind arguably unfair editorials in the Wall Street Journal where one gets the impression he is Miller reincarnate. Let action speak. If he fears inflation credentials are at risk hike June29. I think the justification for a move can be convincing, even if somewhat unnecessary. Capacity is constrained, commodity prices are high if off bubble peaks, global growth is strong (safety net) and inflation expectations have an upward bias while inflation itself is running about where Fed thought it would but in Moskow's parlance it is at the upper end of the comfort zone. So one and pause. Or just pause and go with your belief or forecast that there is enough in the pipeline. Okay it may cost you on the credibility side, especially if May CPI and core PCE prices surprise to the upside. But markets will get over it. The fact is that the US economy is slowing and the need to tighten waning even if it means a near-term steepening in the curve. If image matters more than the forecast, then hike June29. If you are comfortable in your own shoes and not attempting to be the next Wizard of Oz like Greenspan, then pause.

David Gilmore
FXA
www.fxa.com