We expect the Fed will continue to adjust the Funds rate according to a measured pace, as in equal increments of 25 basis points at each FOMC meeting, with the possibility that one or more of these steps could reach as high as 50 basis points if inflationary pressures or the risk of higher inflation becomes more pronounced. We think the markets will find it easier to form their expectations based on a repetitive strategy rather than trying to understand the often obfuscating "open-mouth" policy. However our advice is not to look back but to look forward. The question is not whether numerically the increase from 1.00 to 1.50 percent that has already occurred in the Funds rate represents a major adjustment, since it is from such a low base rate, but by how much further above 1.50 percent does the Funds rate need to go in order to reach a "normal" level that is compatible with continued economic growth, manageable inflation, and a stable dollar. An inflation rate of 3.0 percent next year would imply a Funds rate of 3.50 - 3.75 percent.

The latest trend in oil prices is reminiscent of the mid 1970s, when the surge in oil prices at that time was accompanied by accommodating monetary policy, a mixture that fueled the flames of inflation reaching a 12 month rate of 12.3 percent by December 1974. We think the Fed is now trekking on perilous grounds. If the Fed continues with the quarter point per meeting strategy, then the Funds rate could end the year at 2.25 percent. The long end of the yield curve (20 year bond) could reach 5.75 percent by December of this year, followed by another 50 to 75 basis points next year.

We think that one of the reasons why the long end of the yield curve has not yet moved up is that markets are confused about how to measure inflation. Long-term nominal interest rates are determined by the real interest rate factor, historically about 3.25 percent, plus expected inflation. However, if there are three or more definitions of inflation, market players are bound to get mixed up in forming their expectations. Traditionally, US financial markets have traded on the basis of the CPI inflation index. In recent years policy markers have devised new measures, which not surprisingly show a lower inflation rate, such as the "core" inflation index – which argues that good and energy should not be counted; and the personal consumption index, which the Fed considers the "true" measure of inflation. So investors who buy into the "inflation is not more than 1.0 percent" theory espoused by our monetary authorities, would conclude that now is the time to buy bonds. On the other hand, simple consumers, as those surveyed by the University of Michigan, showed inflation expectations based on the CPI index of 3.0 percent in July, down from 3.3 percent in June; although these expectations have been trending up since the latter part of last year.

Another source of interference in the markets is the over-reaction to financial market news. Headline analysts are quick to change their mood from the somber view that high oil prices are fueling inflation in one month to jubilant exultation when the next month’s inflation rate leads them to conclude that oil prices have no sustainable impact on inflation. We think oil prices affect much more than the cost of gasoline at the pump, almost all goods and services are produced with energy input and from petroleum by-products. When the prices for these goods rise, their higher costs are subsequently passed on to the next level on the production chain. That is why we use the 12 month moving average of the CPI, which we predict will reach about 3.0 percent by the end of this year, up from its July rate of 2.3 percent.