Rita has the financial markets on edge, but don’t be distracted from the main event: the Fed’s calculation of inflation risk and the economic cost to control it.

Mortgage rates fell before and after the Fed raised the overnight cost of money another .25 percent to 3.75 percent, and made clear that more .25 percent hikes are coming. Mortgage money is back near 5.75 percent, the 10-year T-note now 4.2 percent from 4.26 percent pre-Fed.

Rita has the financial markets on edge, but don’t be distracted from the main event: the Fed’s calculation of inflation risk and the economic cost to control it.

Mortgage rates fell before and after the Fed raised the overnight cost of money another .25 percent to 3.75 percent, and made clear that more .25 percent hikes are coming. Mortgage money is back near 5.75 percent, the 10-year T-note now 4.2 percent from 4.26 percent pre-Fed.

During the last year of Fed tightening (11 quarter-percent moves so far), the 10-year T-note has stayed within a quarter-percent of today’s yield, and the spread versus short-term rates has all but disappeared. If you have time to watch one economic datum, just one, watch the 2-year T-note versus the 10-year. Those yields are posted on 15-minute delay on the bond pages of Yahoo, Bloomberg and Pimco.

If the 2s-to-10s spread widens, the bond market is worried that the Fed is not tough enough. That’s what was going on post-Katrina, when the market feared the Fed would grow timid after the storm, just as ever-higher energy prices put even more pressure on inflation. The spread tightened just before the Fed’s meeting as traders began to understand that Katrina had not materially slowed the economy, and the Fed would proceed. Had the Fed flinched on Tuesday, we would be talking about 6 percent-plus mortgages today, and 10s racing away from 2s.

Yes, I hear the shouting in the back of the room. Aren’t high energy costs going to slow the economy? Hasn’t the bond market improved every time energy prices have gone up in the last year, betting on energy-cost drag, not inflation? Hasn’t it?

Sit down, says the Fed. Reconsider your jerking knee. Constant-dollar oil and gasoline prices are today only about two-thirds of the 1980 spike, and constant-dollar national income has risen 75 percent since then. Today’s energy spike has perhaps one-third the impact of 1980, and our energy economy is more flexible now. Every stationary energy consumer on the planet (one-third of total consumption is non-transportation) is switching from high-cost gas and oil to coal and sour oil. Even three-buck gas has not caused a panicky slowdown; we pay it, and keep going.

Energy costs are braking the economy to some degree, at these levels sawing perhaps 1 percent off of GDP growth. However, GDP is still growing at 3.5 percent, goosed by massive deficits, tax cuts, and low interest rates.

When the Fed sets monetary policy, it considers first the relationship between its own rate and the rate of inflation. The “core” rate of inflation is just barely holding at the edge of danger, in the process of pushing above 2 percent – not bad, but the Fed wants to keep it below 2 percent at all costs. The overall CPI, inclusive of energy and food, is running 3.5 percent, and has been over 3 percent since oil went haywire last year.

Inflation at 3.5 percent and the Fed at 3.75 percent…money is still free! Most think the Fed needs a 2 percent premium to inflation to be in neutral; OK, haircut that by maybe 1 percent because of energy-price drag, and the Fed ought to be 4.5 percent. Minimum. Fast. By the end of January, three .25 percent meetings hence. That’s assuming core CPI stays under some control, and the Fed doesn’t have to go from neutral to tight.

Wouldn’t 4.5 percent-plus cause a deep slowdown, maybe a recession?

Exactly. Back to 2s-to-10s: if the spread stays tight (3.96 percent-4.2 percent today) or tips upside down, it’s a bet by several tens of trillions of dollars that we’re headed for a near-recession event.

Not a conundrum. Not the result of an ignorant Chinese central bank that can’t think of anything to buy except the 10-year. Not excessive faith in low long-term rates, as the Fed suggests in frustration, furious that the market correctly anticipates the Fed’s willingness to accept a slowdown to keep inflation under control, thereby making the slowdown harder and riskier for the Fed to accomplish.

Maybe a Cat 2 slowdown, that bad only because the credit shutters are open.

Lou Barnes is a mortgage broker and nationally syndicated columnist based in Boulder, Colo. He can be reached at lbarnes@boulderwest.com.

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