Don't believe the 'tough guy' Fed

By Bill Fleckenstein

I have long maintained that the Fed does not care about inflation, because it believes in its own infallibility. I also believe that the Fed will have no trouble explaining away rising prices. The Fed has done so throughout its entire existence (excluding Paul Volcker, of course). And, since Easy Al Greenspan's tenure began in 1987, the rationalizing has been operating in overdrive.

Hawk-talk and manliness

Last week, however, the Fed appeared to switch into vigilante mode. New chief Ben Bernanke's hawkish-sounding comments on June 5 received credit for all the selling around the globe. The next day, St. Louis Fed Chief William Poole reinforced that tone when he suggested that a slowing economy alone might not bring inflation down.

Which brings me to this question: Given that attitude, why is it only now that the Fed has suddenly awoken to the reality of inflation -- considering that inflation has been raging for the better part of a year and has been too high for a couple of years?

My answer: The Fed's "manliness" (or credibility) has been challenged, and too many people have been laughing at it. Fed members don't like that, but they desperately want to stop hiking rates. Thus, in an attempt to win back confidence, the Fed has to talk a tough game ... to be able to do what it really wants to do, which is pause. If you want to back off, talk is cheap -- but necessary. So, I'm not at all surprised to hear the rhetoric ratchet up.

Of red stocks and red herrings

Be that as it may, the markets tend to take these guys more seriously than I do. Thus, Bennie is getting blamed for the selling in the stock market. A week ago Friday, however, those same folks didn't seem to be pointing a finger at him when the anemic May employment number failed to inspire a Fed-won't-be-tough rally. Stocks were also down hard before he flapped his jaws the following Monday. The implication being: Stocks are just plain weak right now, with Bernanke's chatter only being the excuse for the selling.

By the time we get to the Federal Open Market Committee meeting at month's end, I expect that the data will be weaker still, allowing the Fed to rationalize whatever level of inflation exists, especially if Bernanke talks a good game in front of it (which he has been doing). And, if perchance he sneaks in one more rate hike, he'll make it clear that the Fed is done for a while. So, either way, I don't think it's much of a big deal.

Piecing together a pathway

As for how and when the stock market capitalizes on the Fed-is-done idea, the upside that it tried to muster (until last Monday) was pretty unimpressive. What happens when the Fed actually is done will be a function of how low stocks have traded beforehand.

Maybe the bulls will be able to put together a better (albeit seriously failing) bounce. But except for the near-term squiggles, I firmly believe that the resumption of the bear market is under way. The path of least resistance now, in my opinion, is going to be down, and future surprises are all likely to be negative as the bear market picks up speed.

Biotech update

Finally, it's not my intention to make this column the Nastech Chronicles, but news occurs as it occurs. Thus, as a follow-up to last week's discussion on Nastech Pharmaceutical (NSTK, news, msgs), I would just offer a brief update on what has occurred since then. (More information can be found directly at the Nastech Web site.)

On Tuesday, Nastech announced a supply agreement with Procter & Gamble (PG, news, msgs). Though expected, nothing in this industry can be taken for granted. (I purchased more Nastech stock on Tuesday and now have a rather meaningful position.)

The following day, Nastech filed for a Phase I trial for PYY, a potential treatment for obesity. This trial, which should not last long, will be to determine the dosing regimen to be used in Phase II trials, which I would expect to begin sometime later this summer. Not that this announcement is good news per se, but at least now the process has begun to move forward. And, as this trial will now be conducted by Nastech, not Merck (MRK, news, msgs), the process will be fairly transparent in terms of information flow. So, folks will be able to keep themselves abreast of developments on that subject.

Most importantly, on Thursday, Nastech received a $7 million milestone payment from P&G, and it will be receiving two more payments of roughly the same size over the balance of 2006. Phase III trials should be under way in the not-too-distant future.

Also on the subject of PYY and Merck, there was a lengthy page-one article in Wednesday's Wall Street Journal titled "Research Chief Stirs Up Merck by Seeking Aid from Outsiders." Based on this article and how events have played out, I can construct a case that in the matter of PYY and Merck, Merck's agenda should have been questioned rather than Nastech's credibility.

Although no one is likely to raise those doubts (because, after all, Merck is Merck and hardly anyone's ever heard of Nastech), if PYY is a success, then it will clearly have been an error on Merck's part -- which will have provided a wonderful opportunity for folks to buy Nastech at an attractive price.

Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily "Market Rap" column on his Fleckenstein Capital Web site. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of CNBC or MSN Money. At the time of publication, Fleckenstein was long Nastech.