While Fed gov Fisher was correct in stating the Fed isn’t held hostage to market pricing of fed funds when it makes its decision, the Fed is vulnerable to manipulation when it comes to inflation expectations.

Under mainstream theory, the ultimate cause of inflation is entirely attributed to the elevation of inflation expectations. The theory explains that price increases remain ‘relative value stories’ until inflation expectations elevate and turn the relative value story into an inflation story.

So far the Fed sees the price increases of recent years as relative value stories, as headline CPI has not been seen to leak into core. However, with capacity utilization high and unemployment low, the risk of inflation expectations elevating is heightened.

The Fed also knows that if the financial press starts harping on how high inflation is going, starts to intensely question Fed credibility, and calls the Fed soft on inflation, etc. etc. this process per se is capable of raising inflation expectations and potentially triggering accelerating inflation.

Therefore, I anticipate extended discussion at the meeting regarding ‘managing inflation expectations.’

And if they do cut the ff rate it will mean they continue to blinded by ‘market functioning’ risk and not willing to take the risk of not meeting market expectations of the cut.

Note the rhetoric of the financial press continues to turn in front of the meeting. First strong economy stories, then inflation stories, note this:

Bernanke May Risk `Fool in the Shower’ Label to Avert Recession

 

By Rich Miller

 

Dec. 10 (Bloomberg) — Federal Reserve Chairman Ben S. Bernanke may have to risk becoming the proverbial “fool in the shower” to keep the U.S. economy out of recession.

 

Renewed turbulence in financial markets puts Bernanke, 53, under pressure to open the monetary spigots wider to pump up the economy. Traders in federal funds futures are betting it’s a certainty the Fed will cut its benchmark interest rate from 4.5 percent tomorrow, and they see a better-than-even chance the rate will be 3.75 percent or below by April.

 

“The Fed has to assure the markets that it’s ready to ride to the rescue and cut rates by as much as necessary,” says Lyle Gramley, a former Fed governor who’s now a senior economic adviser in Washington for the Stanford Group Co., a wealth- management firm.

 

The danger of such a strategy is that Bernanke may become like the bather, in an analogy attributed to the late Nobel- Prize-winning economist Milton Friedman, who gets scalded after turning the hot water all the way up in a chilly shower. The monetary-policy equivalent would be faster inflation or another asset bubble in the wake of aggressive Fed action to tackle the slowdown in the economy.

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