What the FOMC statement didn't say

Today's FOMC statement was unsurprising, and the decision to leave policy unchanged was as expected. The statement reiterated the view that the economy was growing at a disappointing rate, and that "measures of underlying inflation have continued to trend downward."

But the most important part of the statement was what wasn't said. Nowhere was there any mention of the fact that 10-yr Treasury yields have jumped over 100 bps in the past two months (see above chart), while 80% of that rise is due to an increase in the real yield on 10-yr TIPS—a sign that the rise in yields is mostly due to an increase in real growth expectations. Plus, there was not a single reference to the stock market, which is now up almost 12% year to date, and up almost 20% since the Fed first floated the idea of QE2 (see chart below of the S&P 500). The rise in bond yields and the rise in equity prices are classic indicators of a big increase in the market's expectation for future growth. Why couldn't the Fed at least acknowledge this?

Another glaring omission was the failure to mention the fact that the dollar is very weak from an historical and inflation-adjusted perspective (see chart below). The dollar's historical weakness is reflected, not surprisingly, in gold prices which are now at historical highs. A very weak dollar is almost proof-positive that there is an over-supply of dollars in the world. And we still need more quantitative easing?

If the Fed persists in ignoring the market's signals, they will end up making another mistake. It's very unfortunate, since past mistakes (e.g., tightening too much in the late 1990s, then easing too much in the early 2000s) have given us a roller-coaster stock market, huge gyrations in interest rates, and a massive housing boom and bust. Monetary mistakes coupled with fiscal policy mistakes (e.g., last year's $1 trillion of "stimulus" that turned out not to be stimulative at all) have been the bane of the U.S. economy for over a decade now, and it's high time our policymakers learned how to pay attention to the market and how to understand what makes the economy tick.

I'm amazed that the FOMC has managed to ignore the market-based indicators for so long. But I find it hard to believe that this state of affairs can continue for much longer. The bond market vigilantes have only just begun to raise the alarm, and sooner or later the Fed will be forced to take note. The Tea Partiers have already beat our politicians over the head, and that's begun to bring positive change to Washington. Despite the miserable state of affairs, there is still room for optimism.

Retail sales make a comeback

After upward revisions to previously reported data (another reason why government statistics can never be as reliable as market-based indicators such as commodity prices, which have been pointing to relatively strong growth since last July), retail sales are now seen to have surged at a 12% annual rate in the past five months, and they are up 7.7% in the past year. November sales were only 0.3% below their all-time of late 2007. At this rate, December could be the best Christmas ever, and fourth quarter GDP could be substantially stronger than third quarter.

This should put to rest any lingering talk of a double-dip recession, of course. And with the rising confidence that will come with an extension of the Bush tax cuts, the question now becomes how much stronger the economy will be next year.

Producer price inflation still alive and well

The November producer price index rose a bit more than expected, but as the above chart shows, over the past few years there hasn't been much change in the level of inflation according to this measure. Abstracting from the huge volatility of oil prices in 2008, producer prices have been rising at about a 3.5% rate for the past 6-7 years on average, while core prices (ex-food and energy) have been rising a little over 1% a year for the past two years. I note that even though this recovery has been sluggish, unemployment has been unusually high, and there has been an extraordinary amount of "slack" or idle resources, inflation has bounced back faster in the current recovery than it did following the 2001 recession. That's just more proof that inflation doesn't respond to the strength or weakness of the economy as the Fed's Phillips Curve Theory of Inflation suggests.

This next chart puts things in a long-term perspective. It shows the producer price index on a semi-log scale, so the slope of the line becomes the inflation rate. I've indicated different inflation regimes on the chart, beginning with the early 1960s when inflation was as low, subdued and steady as it has ever been (and it's not a coincidence that the U.S. was on a strict gold standard at the time).

Inflation has quickened somewhat since 2004, which not coincidentally was when the Fed first started getting serious about easing policy to pump up the economy and to avoid deflation, but it is still far below the hectic pace of he late 1970s (thank goodness). Easy money hasn't done much for economic growth—and there's no reason to think it should, since a nation can't print itself to prosperity—but it has given us a faster pace of price increases at the producer level. Sooner or later this should give us a quickening of inflation at the consumer level. Put another way, the ongoing rise in commodity prices—industrial commodity prices have risen a total of almost 12% a year for the past 9 years—must at some point translate into higher prices for many consumer items.