An inflated view of inflation?

Traders are on "data watch" to try to get an early warning of any hint of inflation in the US economy. It's as if the only thing the Fed is watching in order to guide its rates moves is inflation. Is manufacturing activity/capacity utilization up or down? Is employment up or down? Are hemlines heading up or down? It gives economists both a chance to earn their salt and to prove they're not worth it.

But it could be that this is an overly focused view of things. It could be that inflation is not the only blip on the radar screen. If so, it would certainly put a sock in those folks who wring their hands and pull their hair and harangue the Fed Folk with whines of "what inflation?" as rates keep inching up.

Chicago Federal Reserve President Michael Moskow gave us a big hint yesterday:

The Fed's 7th District president, who is not a voting member of the rate-setting Federal Open Market Committee under this year's rotation, devoted much of his speech to long-term problems posed by the record U.S. current account gap.

In 2005, the shortfall in the U.S. current account -- the broadest measure of trade with the rest of the world -- reached $805 billion, or 6.4 percent of gross domestic product, a level some economists view as unsustainable.

"An economy the size of the United States cannot run large current account deficits indefinitely," Moskow said.

Eventually countries investing in the United States, such as China, Japan, developing East Asian nations and major oil exporters, "will reach their desired allocations of U.S. assets," he said.

"They're going to want to bring back and invest in their own countries," Moskow said, adding that the timing and pace of such a trend was hard to estimate.

Traders, who periodically fret about a messy unraveling of the current account gap that might send long-term U.S. interest rates soaring and trigger a steep fall in the dollar, keyed off this remark.

"He said at some point Asians will bring funds home, which wasn't very helpful ... One response may be the Fed having to raise interest rates to keep the dollar from collapsing as a result," said Michael Panzner, head of sales trading at Rabo Securities in New York.

"There is the possibility, however remote, that current account imbalances could unwind in a more disruptive way."

Variables such as the current account deficit, the dollar or asset prices should not be targets of Fed policy, he said.

It is curious that he worried so much about the current account deficit and the dollar but then said it should not be a target of Fed policy. Probably that is more a reflection of a demarcation line between the responsibilities of the Fed and the Treasury. But even if it is not a policy target, it is an obvious worry.

Moscow did make a few other remarks about inflation but they were capable of being interpreted as much benign as hawkish. Nevertheless, the rates warriors raised a fuss and sent yields several ticks higher after his remarks.

For now, the U.S. economic outlook looks good, although inflation expectations bear watching, Moskow said in a question-and-answer session after a speech to the European Economics and Finance Seminar.

He said the Fed stands ready to act if necessary but that at the moment core U.S. inflation remains under control.

"We want to be very careful that inflation expectations do not increase," he said, terming price stability a "prerequisite to maximum sustainable growth."

Moskow's comments on inflation and the dangers of the big U.S. current account deficit roiled stock markets <.DJI> and triggered selling in U.S. Treasury debt markets . [Id.]

SmartMoney.com noted the 10 year yields got to 4 year highs:

The benchmark 10-year Treasury note's yield reached its highest level since June 2002 in intraday action, reaching 4.907%, before falling back.

The benchmark note last was down 11/32 at 96-30/32 with a yield of 4.895%, up from 4.836% at Wednesday's close.

The 30-year bond was under heavier pressure, falling 28/32 to 92-26/32 with a yield (TYX) of 4.965%., its highest level since the long bond was revived by the Treasury Department in February.

The 2-year note last was down 1/32 at 99-20/32, yielding 4.825%.

The Fed's monetary policy committee is widely expected to lift the fed funds rate to 5% at its May meeting, and traders appear to be pushing yields up to that level in advance of the meeting.

New remarks from Chicago Fed President Michael Moskow about inflation unnerved the fixed-income market, intensifying price losses. The market abhors abhors inflation because it erodes the value of bonds.

During a question and answer session at a London financial conference, Moskow said that "[ ] we want to be very careful that inflation expectations do not increase... if inflation expectations change, we would respond accordingly," according to Action Economics.

When you add the warnings of New York Federal Reserve President Timothy Geithner as mentioned in yesterday's post, you can see the Fed has more things on its mind than inflation alone.