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The Canary Chirps Again on Inflation

Immediately following the release of the Fed's statement yesterday, which took a much more dovish stance against inflation than a few weeks ago, gold prices surged and the dollar plummeted. Like a canary in a coal mine, these market movements indicate that a "pause" by the Fed in its rate hiking campaign would be an inflationary mistake.

Before advanced technologies, coal miners used caged canaries as a signal for the build-up of dangerous gases. If the bird died or had problems breathing, the miners knew there was a problem.

For inflation, the canaries are commodity prices and the value of the dollar. The sensitivity of these markets to detect monetary policy ease or restrictiveness has become very clear in the past decades. If the Fed prints too much money, commodity prices rise and the dollar falls. When the Fed is too tight, the opposite happens.

The price of gold fell from roughly $400/oz. in 1996 to less that $260 in 1999. Other commodity prices also fell, while the dollar surged to its highest level in decades. Despite these early warnings from gold and the dollar, the Fed was still blindsided by a brush with deflation in the early 2000s. It did not pay attention to the canary; and this was a huge mistake.

Since 2001, with the Fed fighting deflation, gold and other commodity prices have been on the rise and the dollar has been falling. These are early signs of an overly accommodative monetary policy, and it should not be surprising to see "core" measures of inflation beginning to rise. Nonetheless, many on the Fed and a large contingent of private sector and academic economists downplay the signals sent by these markets.

One typical argument is that commodity prices play only a small role in the US economy, especially as services grow relative to manufacturing. But this argument misses the point. It is not the feed-through of rising commodity prices (even oil) that causes inflation. Rather, it is easy money that causes inflation, and the sensitivity of these markets to dollar liquidity means that they provide the earliest warning sign of a Fed mistake. Commodities and currencies are traded every moment of every trading day and their prices are finely calibrated with the supply of dollars in the system.

(Brian Wesbury is the Chief Economist for First Trust Advisors in Chicago, IL)