The Associated Press reports that mortgage rates are back up to where they were in August 2007. How can that be? After all, since then, the Fed has cut its Fed Funds rate from 5.25% to 2%. I guess Federal Reserve Chairman, Ben Bernanke's effort to forestall another Great Depression by flooding the zone with more debt has fallen victim to the law of unintended consequences.

While his efforts have not loosened the credit crunch, they have succeeded in boosting inflation to levels not seen in decades. And isn't that exactly the thing that the Fed is supposed to prevent? I was stunned to see that, as AP reported, the rate on 30-year mortgages hit 6.63% this week -- up significantly from last week's 6.26%. It hasn't been that high since August 1, 2007 -- when it hit 6.68% -- before the Fed started cutting rates.

This makes me wonder whether the Fed would have been better off leaving rates at 5.25% last fall. If so, it is likely that inflation would have remained lower instead of spiraling out of control and driving gasoline prices over $4 a gallon, tripling food prices and putting those who are paying now to heat their homes this winter into sticker shock. Simply put, the Fed rate cuts have not uncrunched credit but they have boosted inflation.

The Federal Reserve Bank of Kansas City released its Beige Book Report detailing economic activity among the twelve Federal Reserve Districts across the country. The pace of economic activity was quite sluggish throughout much of the country. At the same time, there have been hawkish comments recently by several Fed governors. This leads us to the question of the possibility of a Fed rate increase on the horizon.

However, one must remember that hawkish talk is quite different from hawkish action. As I have said in my book, Follow the Fed to Investment Success, "watch what the Fed does not what it says."

The Fed has given no indication that an imminent raise in interest rates is forthcoming. There have simply been hawkish comments, which are an incredibly inexpensive means of maintaining its inflation-fighting credentials. However, every time market turmoil arises, the Fed adopts a more conciliatory tone.

Wall Street's consensus regarding the Fed's likely next monetary policy move appears to shifting.
Up until late spring, the Concrete Canyon had, for the most part, projected that the Fed's likely next move would be an interest rate cut. In an effort to reduce building price pressure in commodities, and, by extension, inflation. The Federal Reserve has kept short-term interest rates at 5.25% for about a year. The Fed's tactic has successfully slowed the economy, with U.S. GDP slowing to below 1% growth in Q1, but it has also produced complicated results regarding inflation.

The inflation situation remains "complicated" -- which is Wall Street terminology for "we're not convinced the monetary policy is working on all fronts, yet..." -- because while consumer price inflation remains low in historic terms, core inflation, as measured by the core PCE indicator, remains at the upper-end of the Fed's comfort zone. The most recent reading regarding core PCE indicated it dropped to a 13-month low of 2.0%. True, it dropped, but at 2.0%, that still is higher than what the Fed would like to see.

And that upper-end concern has not been lost on Wall Street, with some major firms shifting their monetary policy outlook.

For example, Stephen Gallagher, economist for Societe Generale, told Agency France Press that he no longer believes the Fed will cut rates -- which only a scant month or so was the consensus on Wall Street -- and instead now believes the Fed's next move will be a rate hike.

Today on CNBC, the network interviewed two ex-Fed Governors at the same time for routine commentary ahead of tomorrow's FOMC decision on rates. The interview just ended about 2:20 PM EST. Former fed governors Alfred Broaddus (ex-Richmond) and Robert Parry (ex-San Francisco) both commented that they would expect the next rate move to be a hike rather than an ease. No specific timeframe was given and inflation and equilibrium were both noted as higher than recent the more comfortable trend.

One metric CNBC posted was that The Financial Times says 40% of fund managers expect a hike in next six months. This was more targeted for 2007 than 2006, and no specifics were given other than a "trend."

Just yesterday PIMCO's Bill Gross, the big daddy of the bond market, was saying rate cuts would be necessary in 2007. One needs to recall that ex-Fed governors are not as widely tuned in as the markets think and they often get current predictions wrong. That isn't meant to discredit the statements made at all, but it should at least be kept in mind. But based on these calls in a Gross versus ex-Fed Governors, one has to be right and one has to be wrong.

This "next move is higher on rates" also was not targeted at all toward tomorrow's FOMC decision on rates, but you may see some play in the farther months' Fed Fund Futures since you had two former Fed governors discussing this simultaneously.


Jon Ogg is a partner in 24/7 Wall St.

U.S. Treasuries and the dollar traded flat, waiting for word on rates from the Federal Reserve's October two-day meeting, which ends tomorrow. Most Fed Watchers expect the Fed to hold the line on rates at least for now, but expect rate hikes in 2007. Right now economic activity is a mixed bag. The weakest part of the economy is the real estate market, but other areas of weakness were seen as well in the past week.

Factory activity in some parts of the country is weak. The Conference Board reported its index of leading indicators edged up slower than expected by just 0.1%. Economists were expecting to see a 0.3% advance. Consumer expectations and money supply were up, while building permits and average weekly manufacturing hours were weak. The biggest surprise to many was a report from Bloomberg on Oct. 23 indicating that the Fed's September Green Book (Fed staff projections) implied that unless the economy slows more than the Fed now expects, the central bank may have to start raising rates.

Federal Reserve Chairman Ben Bernanke certainly echoed that sentiment about three weeks ago when he said, "We have to watch carefully to make sure that [inflation] doesn't rise or even remain where it is," according to today's Wall Street Journal. Bernanke makes it clear that he not only wants to see the core inflation rate, which does exclude food and energy, hold steady -- he wants to see it go down.

Remember Ben Bernanke champions "inflation targeting," which essentially means you set an inflation rate and make sure the economy stays at that rate. It can be a very inflexible marker. In fact, he wrote one of the key books on it, "Inflation Targeting: Lessons from the International Experience" (Princeton University Press, 2001) and one of his co-authors for that book now sits on the Federal Reserve Board with him, Frederic Mishkin. Many believe the consensus for inflation targeting is growing among other Federal Reserve Board members as well.

While Alan Greenspan was an inflation hawk, he believed in being more flexible when setting rates. Whether Bernanke can see the value to flexibility will only be known by reading the minutes to the Federal Reserve board meetings, especially the ones for October, which won't be out until November. But, do expect rate hikes by 2007 unless we see a more dramatic slowing of the economy.

I just got off the phone with Doug Roberts, founder and chief investment strategist at ChannelCapitalResearch.com. Doug is an expert on Fed policy, so I was eager to get his views on why the market is soaring in response to today's rate hike. The following are excerpts from our discussion:

First off, were you surprised by today's Fed decision?

"No, it was what I expected. I didn't think there would be a 50 basis point move, although I think we will see another 25 basis point hike in August."

Why do you think the market is rallying so much post announcement if it wasn't a surpise?

"I think the actual Fed decision was almost an encore for the main act -- which was the good news on GDP this morning. That report showed investors that the current pace of interest rate hikes isn't killing the economy, which is everybody's main concern. Actually, this morning's data was almost perfect since it showed the economy staying strong while employment slowed somewhat, which should ease inflationary pressures."

But the market has run up a lot today just since the Fed announcement.

"Right. A look at the Fed statement explains the run up. The reason investors were cheered by the Fed statement is that it shows that any future Fed moves will be dictated by the data. That says to investors that if the economy suddenly serious slows, the Fed will take that into account.

In this situation, I think what investors really want to know is that the Fed won't overshoot and if Bernanke makes a mistake, he will reverse himself quickly.  It's not the absolute level of rates that matters, but how the Fed will react if it makes a mistake and the economy deteriorates.

I also think there was some short covering. And, finally, some investors who didn't want to be overly exposed to stocks before the decision, are coming back into the market now."