Thoughts Ahead of Fed Decision

Well, today is Fed day, and virtually everyone expects a pause at 5.25 percent. From a supply-side point of view, however, the issue is not as clear-cut. It really boils down to who do you trust: bonds or gold?

The bond market is telling the Fed to pause with long rates dropping below short rates. On an inflation-indexed basis, the yield curve is also inverted. This suggests tight money and a recessionary economic threat.

Gold is sending an entirely different message. While down from its May peak of around $750, gold is trading a little over $650. A year ago, gold was close to $450. Of course the flip side of gold is the dollar, which is also trading weaker. It's almost impossible to reconcile the different messages of bonds and gold.

To some extent, gold is moving with oil, where the September oil contract is just under $77, up from about $58 last December. Perhaps both gold and oil are trading on geopolitical risks, primarily from the Middle East. But if money were truly scarce, you can't help but wonder why both of those commodities are still so high.

Inflation expectations, measured by the TIP spread, are around 260 basis points, about 40 or 50 basis points higher than year ago. Again, if money were really scarce, one would think the breakeven inflation spread would be narrower.

The economy is not nearly as weak as the Keynesian demand-siders would have us believe. Economic growth looks to be moving toward 3 percent, but the split inside nominal GDP has moved toward higher inflation and slower real output. That's the real crux of the Fed's problem. In the second quarter GDP, inflation ran faster than real growth. A touch of stagflation, if you will.

My preference would be a 5.5 percent fed funds rate, then a pause after that.