Saudi/Fed Teamwork: Will Price Hikes Lead to Rate Cuts?

It looks like markets are still trading with the assumption that as the Saudis/Russians hike prices, the Fed will accommodate with a rate cut.

That’s a pretty good incentive for more Saudi/Russian oil price hikes, as if they needed any!

Likewise, the U.S is a large exporter of grains and foods.

Those prices are now linked to crude via biofuels.

And the new U.S energy bill just passed with about $36 billion in subsidies for biofuels to help us keep burning up our food for fuel while keeping their prices linked.

This means CPI will continue to trend higher, and drag core up with it as costs get passed through via a variety of channels. In the early 70s, for example, core didn’t go through 3% until CPI went through 6%.

Ultimately everything is made of food and energy, and margins don’t contract forever with softer demand. In fact, much of the private sector is straight cost plus pricing, and the government is insensitive to ‘demand’ and to the prices of what it buys. And the U.S government indexes compensation and most transfer payments to (headline) CPI.

And while the U.S may be able to pay its rising oil bill with help from its rising export prices for food, much of the rest of the world is on the wrong end of both and will see its real terms of trade continue to deteriorate; not to mention the likelihood of increased outright starvation as ultra low income people lose their ability to buy enough calories to stay alive as they compete with the more affluent filling up their tanks.

At the January 30 meeting, I expect the Fed to be looking at accelerating inflation due to rising food/crude, and an economy muddling through with a q4 GDP forecast of 2-3%. Markets will be functioning, banks getting recapitalized, and, while there has been a touch of spillover from Wall Street to Main Street, the risk of a sudden, catastrophic collapse has to appear greatly diminished.

They have probably learned that the Fed funds cuts did little or nothing for ‘market functioning’ and that the TAF brought ff/libor under control by accepting an expanded collateral list from its member banks.

(In fact, the TAF is functionally the equivalent of expanding the collateral accepted at the discount window, cutting the rate, and removing the stigma.)

And they have to know their all important inflation expectations are at the verge of elevating.

They will know demand is strong enough to be driving up CPI, and the discussion will be the appropriate level of demand and the Fed funds rate most likely to sustain non inflationary growth.

Their ‘forward looking’ models probably will still use futures prices, and with the contangos in the grains and energy markets, the forecasts will be for moderating prices. But by January 30 they will have seen a full 6 months of such forecasts turn out to be incorrect, and 6 months of futures prices not being reliable indicators of future inflation.

Feb ff futures are currently pricing in another 25 cut, indicating market consensus that the Fed still doesn’t care about inflation. This might indeed be the case.