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The stock market was surprised, and shocked on Tuesday to learn that the Fed wasn't cutting interest rates. The initial reaction to the news of standing pat with Fed funds: sell first and ask questions later. But the surprise and shock was fleeting, and investors did an about face, and decided that holding rates steady was the best course after all. Buyers then proceeded to bid prices up.

The net effect was that the stock market was on a roller coaster on Tuesday even though the central bank continued its long-standing policy of sitting on its hands, as defined by Fed funds, which still stands at 5.25%. For those who watch Fed funds futures for clues, yesterday's news of letting it ride was a yawn. The futures market has long anticipated that 5.25% would remain the standard.

But if futures prices can be trusted, a cut of 25 basis points to 5.0% is coming by late this year or early in 2008. One school of thought thinks a cut makes sense in part because of the current credit crunch that's thrown the capital markets into a tizzy. But while the Fed has a history of coming to the rescue in times of liquidity squeezes, there's reason to wonder if erring on the side of monetary caution remains the better choice at this juncture. For the time being, the credit crunch isn't all that crunchy. Liquidity has dried up some, but that's only relative to the recent levels of excess. In any case, so far there's still lots of cash looking for a home in the global markets.

Meanwhile, consider the Fed's preferred measure of inflation, which is also known as the personal consumption expenditures index less food, and energy. The latest report shows the gauge rising at 1.9% for the year through June, which is within the upper range of the central bank's reported comfort zone of 1%-to-2% core inflation. That's the first time in more than three years that the annual rate of core PCE has dropped below 2%.

Why, then, is the Fed still worried about inflation? Tuesday's FOMC statement advised:

Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.

Perhaps the Fed's keeping an eye on headline inflation, which has been running hotter than core inflation for some time. Arguably, this is of no consequence. The academic literature argues that core inflation is superior predicator of headline inflation than headline itself is. In addition, some studies also show that rising energy prices alone aren't fated to elevate inflation. Bernanke is a party to this line of thought and has co-authored studies to that effect. All of which gives the Fed some cover in light of the fact that energy has been driving headline inflation higher at a faster pace than core.

But there's a potential glitch in the pay-no-attention-to-headline-inflation theory. The gap in headline inflation over core inflation is fairly wide, and persistent by the standards of the past 15 years. Does this mean that things are different this time, and that headline inflation is now a better indicator of inflation? If so, does headline's faster pace imply that that the Fed has much less room to cut interest rates than some believe?

The market will have to sort this out, of course. Meanwhile, we're looking at the data. Consider the graph below showing the accumulated impact of headline inflation's pace over core. It's clear that headline PCE has been running faster than core PCE. In the previous economic cycles, the two measures eventually converged. This time, however, there's precious little sign of a conversion.

Comparison of Inflation Measures

Some of the disparity between now and then comes out in a comparison of annualized changes in inflation. For the five years through this past June, headline PCE rose by 2.6% a year, which is well above the roughly 2.0% rate for core PCE. In the previous five-year span (1997-2002), headline's edge over core was much smaller, at about 10 basis points. And in the 1992-1997 stretch, headline PCE actually ran slightly below core PCE's pace on an annualized basis.

It's unclear if headline's higher, persistent pace is a temporary anomaly or a trend that foreshadows trouble. For the moment, the Fed's not dismissing the latter notion.

Source: The Fed and Interest Rates: Is There a Cut in Your Future?