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Real-time Monetary Inflation (last 12 months): -0.5%

Traders and investors have been on tenterhooks this week trying to divine the extent of the Fed's next round of quantitative easing. Fed-watching is nothing new, but it's not just the usual cadre of traders and dealers eyeballing the central bank's moves anymore. John and Jane Public have piled into commodity-based investments, among other things, in anticipation of a big slug of Treasury purchases.

When the Fed buys bills, notes and bonds, cash is injected into the banking system, potentially fanning the embers of inflation. Ergo the interest in commodities—the ultimate barometer of inflation.

That's, in fact, one of the inputs employed in calculating our Fed Operation Indicator (see it illustrated in "The Dollar Is A Third-Rate Currency")—a predictor of Fed open market operations.

The Fed Operation Indicator is another in-house metric, like the Gold Insurance Cost Index (highlighted in "Gold's Insurance Cost Index Explained").

A reader's asked for a description of the gizmos and wheels driving the Fed Operation Indicator, so here goes ...

The indicator relies upon two inputs: the Thomson Reuters/Jefferies CRB Index—a benchmark tracking 19 diversified commodity futures contracts—and a maturity-weighted Treasury securities index. The Treasury index is proprietary, but you can create your own with an amalgam of iShares Barclays Treasury Bond ETFs: SHY for the 1-3 year bucket (61 percent); IEI for 3-7 years (21 percent); the 7-10 year span's covered by IEF (7 percent); TLH for 10-20 years (7 percent); and long bonds represented by TLT (4 percent). The weightings approximate the maturity distribution of outstanding Federal debt.

The indicator's current value is the dividend of the Treasury/CRB index ratio and its 40-week moving average.

When the indicator is above 1.05, bond prices are rising (and yields falling) at a faster pace than inflation, metered by commodity prices. Normally, this would incent the Fed to accommodate. By injecting cash through open market purchases—among other techniques—interest rates would be lowered.

A reading of 0.95 or lower indicates inflation running ahead and signals the need for Fed intervention to hike interest rates.

Readings between 1.05 and 0.95 are neutral.

Fed Operation Indicator



As you can see from the chart, the Fed indicator has wobbled in the neutral zone in 2010. Even more interesting is the indicator's current reading—0.94—which implies a Fed course of tightening, not accommodation.

Now, there are two things you ought to know about the Fed. First, the vagaries of a red line on a chart do not compel the bank to intervene. What the Fed ought to do is a vastly different scenario than what the Fed actually does. Second, the Fed has a number of tools it can use to tinker with the economy. The one most frequently employed is "moral suasion," a fancy phrase for "jawboning." Words are a lot cheaper than Treasury purchases, so if the Fed can "talk" the market into readjusting its expectations, it saves capital—of both the monetary and political sorts.

Over the past couple of days, the doubts that have swirled in the markets about the size of QE2 bear the earmark of such jawboning.

We'll soon find out just how much those words are worth.