Andrew Busch
Global Finance Strategist
BMO Financial Group

Milton Friedman said that inflation is always and everywhere a monetary phenomenon. Today's PPI numbers force us to skeptically look at what the Federal Reserve is doing and whether their policies are seriously behind the curve. Strike that, we know they are behind the curve.

Why? The curve can be elegantly stated as the spread between the Fed Funds rate and the US 2-year note yield. On January 21st, this spread hit a low of -1.9062 pts during the height of the stock market sell off and concerns over the credit crunch. The interpretation was that the Fed needed to ease more to avert the crisis and to take rates below the US 2yr note rate. Eventually, the Federal Reserve cut Fed Funds enough to catch up. This happened at the end of April when Fed Funds were at 2.25%.

However since then, the Ben Bernanke and other Fed governors have been "open-mouthing" rates higher by emphasizing inflation risks. This culminated with chairman Bernanke's comments on June 10th when he said that, "Despite the unwelcome rise in the unemployment rate that was reported last week, the recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly." The Fed Funds-2yr note spread went to a +1.0373 as the yield on the 2yr note soared. Given that the Fed drove the 2yr yields up, this spread shows that they are now behind the curve on raising rates.

Now they have a choice to make. They either have to raise rates in July or August or they have to tone down the hawkish rhetoric. Today's FT and WSJ articles appear to show that they are toning it down. Today's PPI numbers appear to show that they were correct in talking hawkishly about inflation. Today's market response shows that this Fed flip-flopping is generating an equity loss of confidence. They have to make the tough choice between inflation and growth. It's time to choose.

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Andrew B. Busch is Global FX Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. He can be reached here.

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