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The Bernanke Fed caught a break Wednesday morning.

The December report on consumer prices showed that inflation returned to something approximating a manageable level. After November's eye-popping 0.8% surge in CPI, December's 0.3% looks like a gift, and a timely one. No, inflation hasn't evaporated as a clear and present danger, but pricing pressures retreated enough in December to give the central bank a green light to drop interest rates by 50 basis points at the end of the month, when the FOMC meets.

The market expects no less. As we wrote this, the February '08 Fed funds contract was priced in anticipation of a 50-basis-point cut.

It's clear that the economy's slowing and may even be contracting. By that standard, slashing interest rates looks sensible. And thanks to Wednesday morning's CPI report, inflation doesn't appear to be an imminent threat, thereby giving the Fed a clear path for firing up the printing presses at a higher rate in the hope that such action will head off a recession, or at least dull the economic pain.

But make no mistake, despite Wednesday's report: inflation's not dead. A closer look at price trends tells the story. As the chart below shows, CPI's still rising at an elevated rate when measured on a 12-month basis. Last's month's dip helps take the edge off, but inflation running at 4%-plus is a threat, and the Fed can't afford to ignore the threat for too long. On the other hand, if the economic weakness lingers, it will be politically difficult, if not impossible to tighten in a presidential election year.

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Another problem, and a potentially bigger one is the fact that core CPI (inflation less food and energy) continues rising. As our second chart illustrates, core CPI is on the march again, rising 2.4% last year. That's well above the Fed's comfort zone. This is the inflation rate that the central bank watches closely, and the fact that it's rising once more implies that there will be no easy choices this year for monetary policy.

click to enlarge

For the moment, the bond market seems inclined to give Bernanke and company the benefit of the doubt. Worries about inflation are virtually absent among the fixed income set, which is intent on buying. The yield on the 10-year Treasury keeps sinking, and closed at 3.7% on Wednesday, which is the lowest since March 2004. Clearly, bond investors are focused on economic ills, sending a signal to the Fed that avoiding recession is the priority. The only question is whether inflation will play along in 2008.

Source: Bernanke Dodges Another Bullet