The markets are the message

Commentary: As the recession grinds on, the market worries about inflation

PORT WASHINGTON, N.Y. (MarketWatch) -- The economy may still be in recession, but as far as the markets are concerned, inflation is just around the corner.

Late last week, the markets came down with a case of inflation fears. It might have stemmed from an upbeat interpretation of the latest labor-force data, as well as other recent figures, or from speeches given by a couple of Federal Reserve officials.

Whatever the case, the markets have begun to look over the valley of recession to the peak beyond. And as I first warned at the end of last year, what they see is a new round of inflation, made possible by a Fed whose presses are churning out money as fast as they can. ( See my column of Dec. 23, 2008.).

Commodities prices rose a record 20% in May and are still climbing, with gold and silver leading the way. The price of oil has doubled in just four months, while the Baltic Dry Index has shot up six-fold since December.

There is no doubt that the Fed has injected loads of liquidity into the system. Bank reserves now total $900 billion compared to only $11 billion last year. Once the banks start lending, the money supply, already rising rapidly, will grow even faster.

Not surprisingly, interest rates have shot up. Yields on the 10-year Treasury note are just under 4% -- the most they've been in eight months and double levels of just five months ago.

While this was taking place, the yield on the 10-year Treasury Inflation Protected Security barely budged, no doubt a reflection of strong buying demand.

As a result, the spread between these two government instruments is now almost two percentage points. That's the highest since last September, and compares with zero at the turn of this year.

All this talk about inflation has led to a sudden shift in market thinking about Fed policy. From expectations that the Fed would be on hold through year-end, the markets now think the Fed may raise rates as early as the end of summer.

Talk of an early tightening of monetary policy is nothing short of amazing, considering that the recession is 19 months old and counting, and that the unemployment rate has just reached a 26-year high of 9.4%.

Those who expect the Fed to hike rates are also overlooking the fragility of the real-estate market. Housing may be in the process of bottoming, but commercial and industrial real estate appear to be weakening. And if this were not enough, many banks are experiencing big losses in their credit-card businesses.

Then there's the Fed chief himself. Ben Bernanke spent much of his academic career studying the Great Depression and the Fed's role in it. He is not likely to raise rates until he is sure that the economy is strong enough to take it.

Tightening money while the economy is still struggling is also not likely to endear him to the president, who must decide whether or not to reappoint Bernanke as Fed head, come early 2010.

Right or wrong, however, when all is said and done, the markets usually have their way. But given the perilous state of the economy, besides other factors, they might have to wait a while.

By Irwin Kellner, MarketWatch