If there's no inflation, why do we fight it?

By Bill Fleckenstein

Ben Bernanke is no inflation fighter. That was the argument of last week's Contrarian Chronicles. I'll reiterate my view in this column -- but from a slightly different vantage point -- inspired by last Wednesday's release of the consumer price index for January.

As regular readers know, I believe that the CPI is woefully understated, for reasons related to hedonics (see my column "How the government manufactures low inflation"), owner's-equivalent rent and substitution.

(On the last point, see "Yet another way the government hides inflation." As my friend Joanie once defined substitution: "Basically, this approach allows the Bureau of Labor Statistics mathematicians to substitute lesser-price items for those that might have had price increases. They assume, for example, that if tuna is pricey, you might just switch to cat food.")

Whatever the actual rate of inflation is in this country, it's higher than the reported year-on-year price increase of 4%. (Whether the rate is 5%, 6% or some other higher number, I do not know.)

Have your higher-priced cake and eat it, too

What gets me to talking about this is a rather glaring inconsistency. On the one hand, there seems to be denial about inflation being a problem -- witness the repeated use of "core inflation," which is generally used to mean all the things that didn't go up in price. Then, contrast this sanguine view of inflation with the fear that Benny B. is going to get "tough."

If one wanted to make the case that inflation is not under control in this country and that the men at the Fed are serious and intent on doing something about it, that would be a logical, consistent argument. However, the men at the Fed are avowed inflationists. They blew up a stock bubble and refused to do anything about it. Ditto the real-estate bubble.

Meanwhile, they habitually refer to core inflation, as opposed to what is obviously happening, so they can continue on their merry ways. And now, people are worried that the appointment of a Fed chairman whose academic endeavors revolved around fighting deflation means that the Fed will get tough?

I'm sorry, but I just don't think that is logical. In fact, to me, it's a disconnect. The Fed has demonstrated over and over again that it cares about one thing and one thing only: The applause meter. The Fed wants to be loved and keep the party going.

Thus, when I look at the universal denial of inflation on the part of the public at large, Wall Street and the Fed (witness Bernanke's own projections for inflation in 2007 of 1.75% to 2%), I find it quite incongruous that the markets fear the Fed will push rates up to contain something that everyone has agreed is not a problem. (Speaking of the illogical nature of the markets these days, if folks are really worried about the Fed being tough, why are they piling into housing stocks? And why is the PHLX / KBW Bank Sector Index ($BKX.X) breaking out?)

'Indebted' to inflation

In my opinion, the better question is: Why is no one concerned about inflation? Why do the public at large, Wall Street and the bond market act like there's no inflation? My pet theory: Folks have done so well with their homes' appreciation and all the money-printing that, while prices are up, they've chosen to ignore inflation, as it's been "good" to them. Thus, rising prices do not bother them.

A change in psychology will occur when people start to get stung by the fact that their houses aren't going up in price. That will bring their focus to just how fast inflation is climbing. Of course, by that time, no one will really want the Fed to do anything about it because that would mean raising rates at a moment in time when housing prices are likely to be under pressure.

Anyway, I bring all this up to try to illuminate how foolish it is to be worrying about a "tough" Fed. It seems as though stocks and foreign currencies (and the metals markets, to some degree) fear a tight Fed, when, to me, that is the least likely outcome that one could look for. The fact that folks are looking for the wrong thing drives my concerns about being short right now, as I have been saying for the last few weeks.

Laying ground for 'the next time down'

However, I think a major inflection point is going to occur sometime in the not-too-distant future, when folks realize that the Fed is, in fact, done (or about to be done). Only after the Fed has made that unambiguously clear will it be possible for "the next time down" to start. I expect the Fed to do so when the "right" supporting data emerge. If that turns out to be the case, I think there will be quite a big rally in stocks, and an explosion in metals (and currencies). I intend to capture the latter and wait for the former, to take the other side of it.

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.