The jig appears to be up. Many factors have brought us to this point, but it seems that there are two paths left. One or the other will out, eventually.
On the one hand, the Fed may raise interest rates, and thereby support the dollar, which in turn will put downward pressure on oil, which is priced mainly in greenbacks. The alternative path is keeping rates unchanged and so allowing the oil bull market to run skyward unencumbered by any monetary policy braking.
In time, the outcome will be the same: slower growth, perhaps recession, with the possibility of a deep, long recession. Shifting the odds in favor of something tamer, it seems to this observer, requires a proactive monetary policy in the form of hawkish behavior from here on out. Yes, that will incur economic pain. But economic pain is now inevitable. The only question is how it’s administered?
If the Fed does nothing, and effectively allows the bear market in the buck to roll on, the threat of higher oil prices rises as well. In that case, an untethered increase in oil prices from this point will generate more demand destruction to push the U.S. economy, and perhaps the global economy, into recession. In time, that will pare oil prices to reflect the new, albeit temporarily adjusted supply/demand equation.
Alternatively, the Fed could engineer a similar outcome but with a higher possibility of imposing demand destruction gradually, with a kinder, gentler hand compared to the blowback from a runaway bull market in energy. There’s no guarantee, but if Bernanke and company take the lead and steadily tighten monetary policy, and speak forthrightly to the markets about their intentions, there’s a chance that the Fed can minimize the pain.
But let’s be clear about what’s possible, and what’s not. To the extent the higher energy prices reflect higher demand and a growing struggle to find new supplies, monetary policy, enlightened or otherwise, can’t change geologic reality. At the same time, some degree of higher energy prices are a function of the weak dollar. Exactly what degree is unknown. Whatever the degree, it’s almost certainly a small influence on oil prices. Still, the Fed should use its influence, limited though it is.
Rest assured that if the Fed doesn’t act, or doesn’t act with sufficient speed or authority, the markets will eventually do the central bank’s job. In that case, the damage may be greater than if the Fed acted pre-emptively and prudently.

Yesterday’s hefty selling in the stock market may have shocked the perma bulls, but it should come as no surprise to strategic-minded investors. The writing has been on the wall for some time now, economically and financially speaking, as your editor has been pointing out for the better part of the past year.
The challenge, as always, is keeping the long term in focus without getting distracted by the day-to-day tactical issues that emit conflicting signals. Rest assured, much of the financial industry is dedicated to analyzing the here and now, leaving the strategic view up for grabs. If the majority of investors aren’t watching the broader trends, that’s partly human nature; it’s also a byproduct of the instant-gratification culture that’s become part and parcel of the 21st century finance.
But big-picture trends wait for no man. Even so, let’s no kid ourselves: identifying those trends amid the chaos of the daily noise is difficult and prone to error. That’s one reason why we always favor broad diversification across all the major asset classes. Yet we’re also inclined to tweak the weightings from time to time if the valuations enhance our conviction that the future is a bit less foggy in some respects than usual.

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The Federal Reserve yesterday talked about fighting inflation by raising rates, but so far it’s only talk. But while the central bank chatters, inflation expectations continue creeping higher.
Consider the yield spread between the conventional 10-year Treasury and its inflation-indexed counterpart, a.k.a., the 10-year TIPS. The difference between the two yields is a widely followed market-based outlook on future inflation. By that standard, the market anticipates inflation at 2.5%, as of last night’s closing yields. As you can see from our chart below, that’s up modestly from last August’s 2.2% outlook.

To be sure, the rise isn’t dramatic. What’s more, the inflation expectation of late is still middling compared with recent years. But it’s the trend that worries us. Although no one knows the future, the fact that the market’s inflation expectations are rising, albeit marginally so far, reminds that pricing pressures are bubbling and it’s starting to have an effect on investor sentiment.
But before any one gets too comfortable with the numbers, keep in mind that the 2.5% market-based outlook for inflation is well below the consumer price index’s current annual rise of 4.2%, as of May.
Such news may be worrisome to some observers, but the Fed is still expecting salvation to arrive soon and rescue the central bank from the dirty work of hiking rates. As the Fed announced in yesterday’s FOMC statement, it “expects inflation to moderate later this year and next year.”
The question is whether the markets will jump on that bandwagon? There’s still time to debate both sides, but the clock is ticking and resolution, one way or the other, is coming. Much depends on food and energy prices, of course, which are the poster children for the inflation troubles of late. In short, tell us where energy and food prices are headed and we’ll tell you how the inflation soap opera ends. Alas, the story still unfolds one day at a time. Meantime, this is no time to bet the house on one outcome or the other. Hedging one’s bets seems more than reasonable these days.

The market expects no change in the current 2.0% Fed funds rate at this afternoon’s FOMC announcement. Looking out over the second half of this year, however, the Fed funds futures market anticipates higher rates.
The December ’08 contract is currently priced with a 50-basis point hike to 2.5% in mind. It’s any one’s guess if that forecast will hold, or if it’s even worthy of pursuit. Meantime, the central bank continues to grapple with the twin risks of inflation and deflation, as Martin Wolf writes in today’s Financial Times: “Two storms are buffeting the world economy: an inflationary commodity-price storm and a deflationary financial one.”
It’s not yet obvious that the Fed and other central banks are up to the job of collectively navigating the complex macroeconomic waters that define and threaten the global economy in 2008 and beyond. But resolving this challenge, or not, will determine much of what unfolds in the years ahead. The central banks, in short, have their work cut out for them. Hanging in the balance: trillions of dollars of investments, the outlook for the global economy and the livelihoods of the planet’s workforce.
Alas, cracking this nut isn’t going to be easy. For one thing, much of the experience in central banking is dealing with inflation fighting alone, occasionally interrupted by an outright bout of deflation, as during the Great Depression in the 1930s and Japan for much of the past 20 years. Battling both at once is a rare event, which is to say that the Fed’s experience in dealing with such a beast is relatively thin.
Experienced or not, that’s the predicament du jour. On the one hand, inflation is bubbling. Although absolute levels of prices generally are rising by historically modest standards, the fact that the trend has been up for some time sends a warning signal that central banks can’t, or at least shouldn’t ignore indefinitely.
But while inflation bubbles, demand destruction appears to be gaining momentum too. The latest examples include yesterday’s news on tumbling home prices and plunging consumer confidence.

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Inflation is increasingly a global concern. Yes, the risk is still far below the levels that raged in the 1970s and early 1980s, but investors are starting to worry nonetheless. Certainly it’s a sign of the times when the indomitable Ben Stein is wary.
One measure of the collective anxiety can be found in the rising demand for inflation-indexed government bonds. The Lehman Brothers U.S. Treasury TIPS index has risen 13.2% for the year through May 31, vs. 6.9% for U.S. bonds generally via the Lehman Aggregate.
Like so many trends in finance, going global is now part of the game, and inflation-linked government bonds are no exception. In ETF land, for example, one can choose between inflation-linked Treasuries (iShares Lehman TIPS Bond) and its foreign equivalent (SPDR DB International Government Inflation-Protected Bond).
In search of global perspective on the asset class, your correspondent recently chatted with Ralph Segreti, the London-based global inflation-linked product manager for Barclays, in the June issue of Wealth Manager. As we learned from our conversation, the world of inflation-linked government bonds is a growth industry. For more details, read on…

Interest rates are the hot topic once more. The pressing question: when will the Fed hike rates?
Inflation chatter has been in a bull market of late, and the bond market is again focused on the risks. The benchmark 10-year Treasury yield is roughly 4.2% as we write, up from March 17’s 3.3%, which wasn’t far above the generational low of 3.07% set back in June 2003.
The run in yields should surprise no one in a world where prices of commodities–food and energy in particular–have surged. But the fixed-income set, for all its current fears, hasn’t been a reliable and steady barometer of pricing worries. That’s not entirely odd, since bond prices (and their yields) are subject to two key drivers that are often in conflict, and the influence of one or the other waxes and wanes.

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We’ve said it before, and so have others. Now Martin Wolf says it, and far better than yours truly ever could. The U.S., along with the developed economies generally are importing inflation. It’s time to act.
This is not solely a task for the Federal Reserve, writes Wolf in today’s Financial Times. Monetary policy here, and abroad, needs to tighten, he advises. But there’s precious little of that at the moment, and the risk is that global inflation, already bubbling, will take root and become a bigger threat down the road.
The warning signs have been flashing for some time, Wolf reminds, starting with the multi-year bull market in commodities. This is not the result of manipulation by traders; it’s the reflection of a fundamental shift in the supply/demand equation in the global economy.
The “continuous rise in the relative price of commodities is a symptom of an inflationary process,” Wolf writes. “Whenever excess demand hits, the goods whose prices rise first are ones with flexible prices, of which commodities are the prime example. Commodity prices then are a pressure gauge. If we look at what has been happening in recent years, the gauge is showing red.”
The only question, then, is what to do? Ideally, China, India and the emerging markets generally will recognize that their Bretton Woods II strategy–keeping their currencies undervalued relative to the dollar–is contributing to the global imbalances that are fueling inflationary pressures. It’s time to unwind, or at least downshift the strategy that has been so popular in the 21st century.

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The economy has a familiar rhythm these days. Unfortunately, it’s a dangerous rhythm.
Several economic reports hit the street today, and they ring familiar. It’s been clear for some time that inflation is bubbling while the housing sector, among others, is still weakening. Today’s economic updates reconfirms the trends.
New housing starts fell again last month, dropping to the lowest level since the early 1990s, the Census Bureau reports. Meanwhile, the forward-looking metric of new building permits issued slipped in May compared with the previous month, which means it continues to trawl depths last seen more than a decade ago.
There’s also a fresh update on wholesale inflation, and the news is as unsurprising as it is humbling. Producer prices are now rising by 7.2% a year through May, the Bureau of Labor Statistics reports. Once again, the main culprits are higher food and energy costs. Stripping those items away reduces PPI to an annual pace of 3.0%, although that’s the highest since the early 1990s too. The problem is that stripping out energy and food costs, whatever the merits for the dismal science, isn’t possible for Joe Sixpack, who must pay the higher costs.
What are we to make of all this? For starters, there’s momentum in the trends. That doesn’t mean it can’t all end tomorrow, of course, but that’s unlikely. For what it’s worth, this observer thinks that inflation will continue to creep higher and housing and other sectors of the economy will continue to weaken. Nothing dramatic, perhaps, but sudden salvation looks remote.

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Modern finance and socially responsible investing appear incompatible. One is quantitative and unemotional, focused on maximizing return for a given level of risk. The other is the epitome of subjectivity in the realm of money management. But marrying the concept of the “optimal” portfolio with investing strategies that also pursue a greater good above and beyond making a buck isn’t beyond the pale.
Marrying the two seemingly mismatched strategies is Aperio Group LLC, which specializes in tax-efficient and socially responsible investing (SRI) indexing strategies. The nine-year-old firm excels in optimizing SRI portfolios a la Harry Markowitz’s portfolio theory. But while Markowitz’s original idea use expected return and volatility for calculating the optimal portfolio, Aperio revises the strategy by quantitifying each investor’s SRI values in relation to a chosen target benchmark. The goal is building a portfolio that maximizes an investor’s social preferences while minimizing tracking error against, say, the Russell 3000 or MSCI EAFE.
In the June issue of Wealth Manager, your editor profiled Aperio, which is based in Sausalito, CA. The firm claims to that its specialty strategies give investors more bang for their SRI buck. For the details, read on…

These are strange days in the global capital and commodity markets. The macroeconomic terrain isn’t quite familiar either. No wonder, then, that central banking isn’t quite itself either.
The weird aura is second to none in these United States, where the Federal Reserve is battling, among other things, a bout of the unfamiliar and unusual. Two recent commentaries by observers from the dismal science offer a sampling of how life in the central banking trenches is something other than par for the course of late.
“Recent Federal Reserve activities suggest that Chairman Ben Bernanke went from being in charge to losing control of the Federal Reserve in the span of a few days,” wrote Michael Cosgrove (an economist who runs the Econoclast consultancy in Dallas and is a professor at the University of Dallas) in an op-ed this week in Investor’s Business Daily. As a result, Cosgrove wonders if the longer-term direction of monetary policy is “up for grabs” after the election.
The fact that Fed Chairman Bernanke has broken with recent precedent and talked so openly and forthrightly about the dollar is one clue that’s something’s a bit amiss at the central bank, Cosgrove suggests. Another curious sign is the fact that there’s a relatively high degree of public dissent among Fed members in 2008. That’s raising an unusual amount of questions about whether the central bank has a sound monetary policy plan or is struggling with internal fighting.
“It looks like Bernanke, an academic, is attempting to run the Federal Reserve like an academic institution,” wrote Cosgrove. But “Bernanke can’t run the Fed like an academic institution. He needs to learn that quickly, or he will be leaving the Federal Reserve when his term is up in 2010. It may already be too late.”

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