Cezary Salad

Yesterday most major U.S. stock indexes finished the day either flat or slightly lower as markets await with anticipation to see what action the Fed will take at the end of its two-day policymaking meeting that starts today.

It’s a sort of nervous quiet-before-the-storm that comes whenever the markets anticipate a change in direction in Fed policymaking. But this is not just a drizzle; investors are curious to learn how what the Fed’s next step will be in tackling what seems to be the perfect storm of sky-rocketing commodities costs, soaring inflation and a plummeting dollar.

After nine months and 325 basis points of easing, fed funds futures are overwhelmingly pointing to a halt in easing - to be exact, an 87% probability (as of June 20th) that the FOMC will leave the Federal Funds Rate target unchanged, as calculated by the Cleveland Fed.

This comes as no surprise since most economic indicators still point to an uncomfortable netherworld between contraction and expansion that seems to call for a pause and rethink of where the economy is going. The index of Leading Economic Indicators (LEI) - a composite of a group of 10 macroeconomic statistics that are known to change in advance of a contraction or expansion - despite moving higher by a slight .1% last month, gave us little insight since six of the ten components moved down and October through February marked a period of -1.8% contraction in the LEI that fell just shy of predicting a recession (according to the rule of thumb of 2% decline in the index over six months and a majority of components moving lower).

No matter what it decides to do, the Fed will likely highlight this uncomfortable netherworld situation in its statement on Wednesday, warning us of the continuing downside risk and the need to monitor the inflation situation closely.

Important as this may be, though, the real words to watch for in its statement - given recent statements by Treasury Secretary Paulson and Fed Chair Ben Bernanke - will be the dollar and commodities, both of which have been enjoying increasing popularity on Capitol Hill and the campaign trail lately, and for obvious reasons.

Since Mr. Bernanke has taken over as the chairman of the Fed, the dollar has depreciated in value against most of the world’s major currencies (this clever graphic from the Telegraph says it all) - a decline that has only thrown more fuel on flame-hot commodity prices, which have become increasingly correlated with the depreciating dollar over the last year. This should come as no surprise: after all, with credit markets frozen and falling interest rates at home, where were investors to park their money except foreign currencies and a booming commodities market?

Still, as anyone who regularly reads the FOMC’s carefully-crafted and blandly worded policy statements knows, the Fed is unlikely to make a big splash about commodities and the dollar. Nonetheless, investors are curious to know whether all the talk of bolstering the dollar and reigning-in commodities prices really has any policy teeth behind it - which is why the reason behind the Fed’s staying the course, if it does so, will be particularly illuminating.

If it cites the threat of inflation as its primary policymaking motivation, then the case could be made for a prolonged wait-and-see approach since inflation is a lagging economic indicator. On the other hand, if it cites worries about the plummeting dollar and its impact on soaring commodities prices, then there is a strong argument to be made that there is little time to waste since both are already at historic lows and highs, respectively. As a result, the Fed will be expected to raise rates sooner rather than later, (in which case expect to see the implied probability of a 25 bps increase in August edge higher than the current ~20%).

But whether it’s soaring commodity prices, inflation, or a plummeting dollar, at the root of each - as well as their after-shocks in the over-heated housing markets - lies the 2001-2004 Fed easing cycle carried too far and too long. This is why some economists, including Dr. Benn Steil, Director of the International Economics Council on Foreign Relations, have wisely begun to point out that we are currently experiencing not so much the beginning of (yet!) another bubble, this time in commodities, but rather the aftermath of a previous, much larger currency bubble. As Steil testified two weeks ago in front of the Senate Committee on Homeland Security and Governmental Affairs, “the Federal Reserve pushed rates too low and held them too low for too long, and has since last autumn been exceptionally aggressive in driving them well below the rate of inflation.”

The “since last autumn” part is, of course, how we got to this spot in the first place, and doing so again will only continue to widen the yield gap between the United States and the rest of the world, including oil-rich states like Saudi Arabia, which last year for the first time refused to lower its interest rates in lock-step with the U.S. Federal Reserve.

A telling sign of the times? Certainly; but more so a reminder not to repeat the mistakes of the past - even in the face of the perfect storm.