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Herb Morgan (Efficient Market Advisors, LLC) submits: Shortly we will know the legacy of this Federal Reserve Board and its Chairman Ben Bernanke. If nothing else this Fed has been consistent in its communication to markets. Without a doubt the Central Bank has given us guidance that it is committed to “fighting inflation” which, rationally recomposed, means they are committed to a “sound currency”. Sound currency is undeniably a necessary component for strong equity markets.

What remains to be seen is how this Fed defines “inflation”. Is this a Fed that defines inflation by relying heavily on analyses of core CPI and PPI data? Or does this Fed approach the issue in a more forward looking way?

Media based inflation watchers look to core-inflation indicators which strip out the volatile food and energy sectors to report on inflation trends. Core inflation indicators wax and wane in their ability to be a reasonable measure of underlying inflation. Core inflation was a failed indicator in the 1970s; a period in which energy prices performed in a similar pattern to that of today. During prolonged periods of high energy prices, core inflation indicators lag real inflation. If the Fed places too much emphasis on the core inflation numbers, they run risk of letting the economy slip into a recession.

Owners Equivalent Rent [OER] often discussed as an inflation proxy, is the largest component of the core-inflation indicator. Given what is happening in the residential real estate market at the moment it would be logical and reasonable to assume that the next move in this indicator is to the downside. With this assumption comfortably in hand the Fed should feel it is safe to cut rates by .25 bps next week.

Evidence of a slowing economy abounds. We are no longer looking at isolated data from remote regions of Pennsylvania. This level of economic activity will surely manifest itself in OER data and ultimately in core index data. The question at hand is whether the Fed will be forward thinking and cut rates next week or wait until the economic situation worsens before easing.

Historically, Federal Reserve Boards have been too slow to act when easing or tightening was warranted. This Federal Reserve Board would be wise to give us .25% next week. Stubbornly waiting for the inevitable drop in some lagging indicators will help no one.

Source: 'Fighting Inflation': A Defining Moment for the Fed