What really matters to the Fed and why that matters to you

George Osborne drew all the headlines this week.

But the week really belonged to the central banks. I want to talk about that, and why it matters, in a bit more detail today...

What really matters to the Fed

The impact of the US Federal Reserve's suddenly more relaxed attitude towards raising interest rates this year continued to be felt throughout the market.

The Dow Jones has turned positive for the year. Oil prices are near their highest point for this year. Gold has had a good year too.

And yet, this abrupt change of heart isn't necessarily what you'd expect given the backdrop. US consumer price inflation is rising more rapidly than anyone had expected.

As Reuters pointed out, "core" consumer price inflation rose by 2.3% in the year through February. That compares to the Fed's 2% inflation target. Factory output was up. Housing starts grew rapidly, having been held back by bad weather.

Says Reuters: "Builders cannot keep up with the demand for housing because of a shortage of lots and skilled labour, which is driving rents higher in major metropolitan areas."

So inflation is rising. Yet, as Jared Dillian points out in his 10th Man email, the Fed has gone "from being concerned about inflation pressures building to being fairly glib about it".

What does that mean for your money? Well, it's probably worth being prepared for inflation.

One of the takeaways from the financial history course I was on the other week was that stocks do OK under inflation until things start to get really out of hand. With inflation up to about 4%, stocks are cheery enough.

And I think this is important to bear in mind. You see, as far as I can work out, there's one key indicator that the Fed really gives a damn about. It's not employment. It's not wages. It's certainly not inflation.

It's the level of the S&P 500.

It's the little differences

You see, as I've said before, for America, the stockmarket is a bit like the housing market in the UK.

At the end of the day, our government isn't that bothered about where the FTSE 100 is from one day to the next. If it was, you can bet it wouldn't still be knocking around where it was roughly 16 years ago. That lack of interest comes from the fundamental lack of interest and mild distrust that the majority of the electorate has for "stocks and shares".

But property? Every single time the chancellor (this one and his predecessors) stands up to do a Budget, he bumps a little more money the housing market's way. Because he gets it.

He understands that "an Englishman's home is his castle" and all that. If a British homeowner wants to know how the economy is doing, they look at the price of their house. If it's up at election time, they'll vote for the incumbent. If it's down, they'll vote for the opposition.

This is also, I suspect, the driving force behind Osborne trying to kill off buy-to-letters in favour of first-time buyers. If you don't own a house, you can't feel a part of Britain's ever-expanding, ever-wealthier economy.

Anyway. So if the authorities are going to prop up anything in Britain, it's house prices.

In America, it's different. Until the recent bubble, property on average didn't have a particularly attractive record as an investment, and wasn't the be-all and end-all of everyone's financial existences.

But stocks – they're a lot more important. The average British person reckons they can get rich in the long run by owning property. The average American reckons they can do the same with stocks.

So the thing the authorities care about as a popular barometer of economic health, is the stockmarket.

As long as the stockmarket is rising, the Fed will be happy. To me, that rather equates to the Fed being happy with inflation ticking higher and higher, until it reaches the 5% or so mark, at which stocks start to get a little worried.

By that time of course, it's too late to do anything without getting extreme. But the Fed will be so busy worrying about fighting the last battle – the one against deflation – that it won't remember just how nasty an opponent inflation can be until it's right at the heart of the economy.

To cut a long story short – the biggest bubble around right now is in bonds. The logical way for that bubble to pop is inflation. There's a pleasing circularity to the story, but it's not going to be very pleasing for those on the sharp end of that bubble bursting.

We'll have more on all this in future issues. Meanwhile, it's something to keep your eyes peeled for.