The market fears the Fed, not inflation

By Bill Fleckenstein

Though the inflation genie has been out of the bottle for quite some time, it took Wednesday's consumer-price-index results -- which were reported at 0.3% instead of 0.2%, excluding the bad stuff -- to finally get people's attention. (The wake-up call was not without pain -- witness the bruising that day.)

When one-tenth matters

Before delving into the subject, let me first note how completely absurd it is to get upset about one-tenth of a percent -- especially about a number that's nearly fictional (thanks to hedonics and substitution) and radically understated in the first place. However, this is an example of an idea that doesn't matter until it matters. Then, it's the only thing that matters, and of course, then it's too late.

Regular readers know that I have always believed inflation would be the outcome of the policies pursued in this country. (As the motto on the masthead of my Web site reads: "In a social democracy with a fiat currency, all roads lead to inflation.")

Have no fear, deflation ain't here

It has also been my longstanding belief that if we were ever to experience deflation (color me dubious), it could only happen after inflation had been tried, the dollar collapsed and all of that fed on itself -- an outcome that we could see, but only far down the road. Everyone who's been fretting about deflation for the last five, 10 or even 20 years has been dead wrong, though if they expressed that viewpoint by being long bonds, they made money until recently, despite the error of their central thesis.

Nevertheless, the fear of inflation is an idea whose time appears to have come. I think it's particularly ironic that one of the very fiddles that suppressed inflation while housing prices were screaming (i.e., owner-equivalent rent -- a measure of rent costs factored into the CPI) has now turned and is going the other way -- pushing up inflation at a time when home prices are starting to flatten and head south.

Rents are going up because more folks are choosing that option. More importantly, the price of everything is going up, forcing/allowing landlords to raise said rents. In fact, businesses are tacking on fuel surcharges everywhere, and people are paying up. Thus, the inflation process is well under way and has been well under way.

The interesting question is: Why have people been so complacent about it for so long? After all, it's just been in the last few months that the bond market has woken up to this fact. But, as I said earlier, ideas catch the mind of the market and the crowd only when they do. Inflation is something that has certainly grabbed center stage, as well it should.

The narcotic of rising home values

My answer to why there's been so much complacency about the inflation threat: As long as housing prices were exploding, folks could look past all price increases because they thought that this new-millennium brand of inflation was benefiting them in a big way. And, from a net-worth standpoint, it was. Now that this is no longer the case, and they're starting to feel the squeeze, it's worrisome. In any event, inflation has now become the focus of the market.

The net of this is that it's becoming clearer that the Fed is trapped. Inflation is too high, but the Fed doesn't want to do anything to endanger economic growth, because in the back of Bennie B's mind is his fear of deflation. (For review, please see my Feb. 20 Contrarian: "Bernanke is no inflation fighter.")

For now, folks may actually think that the Fed will fight inflation. So, days like last Wednesday lead to "Fed's gonna be tough" talk. Which is why metals can go down in a session when inflation fears are running on the high side.

Setup for metals' gain, stocks' pain

Nevertheless, as the vise tightens down the road -- i.e., inflation is still not under control, but the economy is clearly slowing down -- you can be sure that the Fed will opt for rationalizing inflation, in the (futile) hope of not presiding over a nasty downturn. That will be the moment in time when the metals (and foreign currencies) really go wild to the upside.

Meanwhile, I believe that the path of least resistance for equities will now be down in the short run. And when we get the next rally, I would expect it to fail, since I firmly believe that the top of this three-year-long bear-market rally has finally been seen.

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, Bill Fleckenstein did not own or control shares of any company mentioned in this column.