The market is obsessed this morning with the possibility that the bailout won't pass and/or we'll have massive bank failures and an ensuing depression; stocks are down and the VIX is back up to 40. While the market sorts out who is going to get stuck with the remaining subprime losses, I thought I'd highlight the inflation figures released today. As the chart shows, the Fed's preferred measures of inflation have been above target since early 2004. Energy prices are clearly the drivers behind the rise in overall inflation, but core inflation (ex-food&energy) has been drifting higher as well. That tells me that the Fed has been effectively accommodating higher energy prices with easy money—allowing higher energy prices to be passed through to other areas of the economy. It's also significant that there is no sign of moderation despite the weakness in the economy and falling housing prices in recent years. Traditional Phillips Curve thinking has held that we should have seen some moderation by now. Instead, the traditional monetary approach to understanding inflation has been more accurate in its predictions.
Barring a gigantic collapse in oil prices, the upward and above-trend drift in inflation is likely to persist until the Fed decides to tighten policy to fight it. With all the focus on saving the economy, that is not likely to happen soon. The gold market has been on top of this, which is why gold prices are in the range of $900 today, up hugely from $300 when inflation hit a low point in 2002-2003. The dollar is up today as the whole world worries about bank failures and the dollar is seen as some port in a storm, but the dollar remains very weak from an historical perspective, and that confirms the message of gold prices; the Fed is not paying sufficient attention to the value of the dollar.
I don't think any of this means the end of the world as we know it. But I do think that we see here the seeds of the next thing the market will worry about once the subprime mess simmers down. Rising inflation has been bad for the economy (inflation is always bad for growth), but an inflation-fighting Fed won't necessarily be bad for the economy. Tighter monetary policy will be bad for Treasury bonds (higher yields) but very good for confidence, and that's good for the economy.