Can the Fed Walk the Inflationary Line?

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Includes: HYG, TIP
by: Brian Kelly

Our take-away from the FOMC statement was that the U.S. Federal Reserve is dissatisfied with the level of inflation (or lack there-of). This should not have been a surprise – if there is one thing Chairman Bernanke has been consistent at, it is telegraphing the Fed intentions. Moreover, the Chairman has spent his career studying the devastating impact of deflation. It is Chairman Bernanke’s background as a deflation fighter that was part of the thesis behind our long gold position.

In our view, the Fed is attempting to fuel inflation in an environment that is already filled with rising prices. We believe it is incorrect for the Fed to be looking at capacity utilization to determine the level and potential for inflation. The FOMC statement indicated that inflation should remain subdued because of the slack resources in the economy.

An integrated global economy like the U.S. has inflationary pressures from more than just domestic factory usage. In fact, the recent increase in import prices indicated inflation is arriving on U.S. shores from our trading partners. Additionally, the global trend toward food supply security has increased commodity prices.

To be sure, inflation and inflationary expectations should result in improved pricing power and help corporate profits; however, this is a very fine line the Fed is walking and we are not convinced the tools at its disposal allow it to be as nimble as the economy requires.

It appears the markets agree with our assessment that the Fed may not be able to walk the line. the following chart shows the percentage change in TIP vs HYG – and serves as a proxy for inflationary expectations.

Click to enlarge:

tip/hyg

We draw the readers attention to the tight correlation prior to 2pm… Once the FOMC statement was released TIP soared, along with inflationary expectations.

Disclosure: Accounts managed by Kanundrum Capital are long TIP and short HYG