Market plays it cool as inflation heats up

By Ros Krasny

CHICAGO (Reuters) - Financial markets have surprised many Fed watchers, drastically marking down the prospects for Federal Reserve rate increases despite a summer inflation heat-up.

Meanwhile, a key market-based measure of inflation expectations has quietly cratered to a multi-year low even as select Fed policy-makers continue to bang the drum on inflation worries.

"We risk a reinforcing spread of inflationary impulses and expectations," Dallas Fed President Richard Fisher, the central bank's most outspoken inflation foe, said in a speech in Aspen, Colorado, on Tuesday.

But with the U.S. economy teetering and credit markets still shaky, perceptions that inflation will give way in the face of the weak economy and rising unemployment appear to be gaining ground over fears that inflation is set to remain high.

Financial traders now see just a one-in-three chance that the Fed will raise rates to 2.25 percent by year end from the current 2 percent. As recently as July 23, the market was leaning toward a year-end rate of 2.5 percent.

"The market is clearly much more worried about slowing growth and the credit crisis than it is about any monetary response from the Fed to try to fight inflation," said John Kosar, analyst at Asbury Research in Chicago.

A slide in oil and overall commodity prices, ranging from copper to corn, since early July has clearly been a huge factor in subduing inflation worries.

"With oil prices down over $30 per barrel since mid-July, headline inflation appears to have peaked, at least for the time being," Goldman Sachs economist Andrew Tilton said in a research note.

In just six weeks, the Commodity Research Bureau index .CRB of commodity prices has given up fully half of the gains made from January 2007 to the July 2008 record high.

"If accelerating inflation is such a threat, why is that perennial barometer of inflation expectations, the price of gold, falling from almost $1,000 an ounce back down to about $800 an ounce?" said Paul Kasriel, director of economic research at Northern Trust in Chicago.

Kasriel said the Fed's key monetary aggregates go even further than the commodities slide to explain why the inflation scare may already have peaked.

The three-month growth rates in variables such as bank credit growth and bank deposit growth "are quite low, and suggest a sharp deceleration in CPI inflation going forward," Kasriel said.

"In U.S. business cycles, first the real economy goes into a recession, then several quarters later inflation starts to moderate, he noted. "The rate of change in the price of assets has been accelerating -- to the downside."

THE TIPPING POINT

The spread between the yield on Treasury inflation protected securities (TIPS) and nominal 10-year Treasury yields fell to 2.15 percent this week, a level not seen since the second half of 2003, from over 2.5 percent in early July.  Continued...