Thursday, June 26, 2008

Stay long the inflation trade

Yesterday’s June 25 FOMC statement acknowledges that the Fed is walking a tightrope between slowing growth, the precarious state of the financial system and the risk of stoking inflationary expectations. In part, it read:
Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.
In other words, the Fed opted to do nothing and go into jawboning mode on inflation.

The trouble is, as this Bank Credit Analyst article points out, commodity inflation is likely to continue until emerging market central banks start to get tough on inflation. Many of the emerging market central banks are already hesitating in their inflation fight (see this) and they take their cue from the Federal Reserve. If an emerging market central bank becomes overly aggressive on inflation then it runs the risk of strengthening their currency and eroding their own export competitiveness.

Conclusion: Stay long the commodity inflation trade, but watch the Baltic Dry Index for signs of widespread weakness in the global economy.