Dropping the Other Shoe

It's no secret that the focus of policymakers and financial markets has dramatically shifted since March. Inflation has overtaken the credit crunch as the central story, much in the same way that Obama overtook Hilary.

Is it me, or has the media's thirst for these two stories (one political, one financial) completely surpassed its capacity to develop original story lines? Well, no matter what the Fed does, it will all be over in November. Oops, wrong script. Make no mistake: The credit crunch isn't going anywhere, and inflation will be with us well past the election returns.

"This is a big deal. Inflation is broad-based. It's across all kinds of commodities. It's going to have major implications for policy. It's going to have major implications for financial markets," explains Larry Kantor, head of research for Barclays Capital. For its part, Barclays recently revised its 2008 inflation forecast up more than a percentage point to 5.0 percent for the calendar year.

According to Kantor, the inflation risk is bigger than anything Americans have encountered from the 1970s on forward, a distinction he draws based upon the speed at which inflation is now growing. "It took five years for oil to go $20 to $60 a barrel, and now it has taken less than a year for it to go from $60 to over $130," he explains.

While the typical consumer response to inflation is to curtail spending, the response of most companies is to raise prices.

"Corporate profit takers actually hedge inflation pretty well. Companies raise prices and revenues can grow commensurate with inflation, but it's the monetary tightening that can get them in the end, when its higher risk premia, and lower P/E ratios," says Kantor.

Last month, as oil reached $140 a barrel for the first time, the Dow Jones Industrial Average dropped 358.41 points, with stocks falling to their lowest point of the year. Earlier the same week, the Federal Reserve ended its steady stream of interest rate cuts, when officials voted to leave its target interest rate unchanged, a development that reflects the Fed's own inflation fears.

"If in two months oil goes back down to $75 a barrel, then we're wrong. But we're arguing that this rise in commodity prices is fundamentally based and that while speculation has played a role, it's a minor one, and it is not the big story. The story is that high commodity prices are here to stay."

Or rather, the story is perhaps that inflation and the credit crunch have now formed their own unity ticket.