Will the Fed Get Tough?

The gold market has sold off $20 today, and my hunch is it has something to do with the Federal Reserve policy meeting that begins tomorrow and will conclude with a public announcement at 2:15 p.m. Wednesday. A big gold drop strongly hints at market expectations for a tough-minded Fed that will defend the dollar and move to contain rising inflation.

Nobody expects the central bank to raise its target rate this week — although frankly I wish it would. In effect, it would be taking back some of the excessive rate cuts made last winter. And I think those rate cuts have a lot to do with the high price of oil and the cheap dollar.

But the gold plunge today might be suggesting some tougher language from the FOMC policy statement on Wednesday. If, for example, the Fed language is biased against inflation, and perhaps even mentions the dollar, it would be a clear signal that rate hikes are coming sooner rather than later.

There’s been a big debate about this, with hawks versus doves arguing over how tough the Fed’s gonna be on inflation. Bernanke sounded very tough, but then Donald Kohn and others seemed to be leaking to the media that they wouldn’t be so tough. Today’s gold drop suggests that Bernanke is going to win the day and pave the way for a quarter-point rate hike either next month or in August. The futures market is pricing in several more rate hikes after that.

I continue to believe that fighting inflation and appreciating the dollar would be the best medicine for the economy, and in the short term would be strong medicine to reduce world energy prices, including gasoline at the pump. If Paul Volcker were running the Fed, speculation would be high today that the central bank would beat the market with a dramatic rate hike announced on Wednesday. Nobody today equates Bernanke with Volcker. And today’s stagflation is certainly a smaller dose than we had in the 1970s. But who knows? Maybe Gentle Ben will surprise us all with a Volckeresque action.