Monetary Policy Issues

The rapid drop in commodities price composites since
the end of 1/06 almost broke the longer term uptrend
in place. But, as this week wanders to a close, the
basic fuels group has been able to stabilize, thus
holding the positive edge for the broader composites.

Now since the acceleration of inflation in recent years
has been driven by commodities and oil and gas in
particular, new Fed chair Bernanke will be watching the
action here with special attention. For example, if
fuels remain stable, the threat of accelerating
inflation will begin to wither as there is still goodly
excess productive capacity in the entire US system.
Such a development would leave the Fed room to stop
raising short rates after another couple of boosts.

So it is heads up time for investors and traders, since
for example, the KR-CRB Commodities Index ($CRB) is
once again right down on trend support. Just keep in
mind what a devilish issue this is, since the CRB has
continually held and rebounded off trend support in
each of the past five years. So, a break and hold below
support would be a big deal for macro policy.

As all know, the US economy absorbed some heavy shocks
over the last four months of 2005, with real GDP dropping
to a puny 1.1% AR in the final quarter of the year. In
response Uncle Al had the FOMC spike the punch bowl with
a full quart of 100 proof rum late in the year. That
plus milder winter weather produced a strong January,
leading FOMC to quickly dilute the bowl by blowing out
about $20 billion in Treasuries from its portfolio.
On balance, the advance liquidity measures such as
Fed Credit and the Adjusted Monetary Base now have a
slightly positive bias, with the leader -- Fed Credit --
now stabilizing after a patented Greenspan roller
coaster ride. Bottom line, if the CRB et al take
a stable path, the Fed may slowly ladle more punch
into the bowl even as it raises short rates and talks
tough.

As discussed a week or two back, the cyclical case
for raising rates somewhat higher remains in place for
now. With Katrina relief and more defense spending
expected to produce a larger budget deficit this year,
It is doubtful the Fed will unrelievedly raise rates.
At some point, revenues would slow or crack, and then
there would be a fine mess. A politically astute Fed
chief would likely cut off pushing up rates well
enough ahead of this very important off-year election
to keep the Fed out of the headlines and the line of
fire. Again, a more gentle movement in commodities
prices would be a boon to Bernanke.

BB did field inquiries at the HH hearings about the
Fed's decision to stop reporting M-3 data. He
politely gave the lame excuse about bankers' complaints
regarding costs they must absorb to gather and submit
the data. By this subtrefuge, Bernanke buys time to
study over what should be done about Greenspan's
foolhardy decision to cede so much of Fed control over
reserves back in 1992 in exchange for having commercial
banks take on much of the burden of the splintered S&L
industry.

M-3 has been zipping along at a 10.8% AR over the past
six months. The liquidity cycle is credit driven and
not monetary driven. In fact, there has been enough
excess liquidity not only to fuel housing prices, but
fuels prices as well! (Glad you are gone Al.) The M-3
phenom keeps the economy and profits rolling, but it
has impaired the Fed's ability to slow inflation. This
issue can play hob with policy, and it will be a good
test of Bernanke's courage and ingenuity as well.