Financial market strategies.

It's "high noon" and Sheriff Bernanke is waiting with gun bolstered for rapid inflation, that most devious of villains, to slink onto the economic scene. Bernanke has already laid down the challenge in recent speeches. The problem is, he may actually have to do battle if oil prices do not recede or stabilize soon. I call this a problem because I'm not sure if the town is ready for this event so soon after Sheriff Bernanke chased off the financial-market crisis gang from taking over the town.

In recent days, investors have been like the town's folk, ducking for cover before the bullets fly. I was in attendance at the Boston Fed's Inflation Conference this week when Bernanke downplayed the half percentage point jump in the May unemployment rate and reiterated the view that the downside risks to growth have diminished. Hey, I agree with the man. I've written about it in recent publications. The healing in the fixed income markets and improved tone in the high-frequency economic data is real and was echoed in the Fed's June beige book report that cited sluggish activity but fewer regions of economic decline. Yet, is it really time for the Fed to open up another front against another enemy before it has finished off its first adversary? Yes, the Fed has won some important battles since March 14, 2008, when it provided emergency assistance to Bear Stearns, but is it really all quiet on the Western Front? The reaction of bank stock prices, Lehman Brothers' stock (which has dropped nearly 50 percent over the past 30 days or so), and interest rates to the Fed's hawkish language suggests that financial and credit conditions remain awfully shaky. The Fed's swift change in policy stance feels a bit premature, like the track and field star that jumps the gun because he can't wait to get down the strait away.

Indeed, the Fed's recent tough love stance on inflation threatens to undo the gains made in credit and financial markets since March 14. Crude oil has hardly been cowed (last I checked crude oil was still at around $136 per barrel), and interest rates that had been trending in a pretty mild range are skyrocketing higher. The 10 year Treasury yield jumped from 3.90 percent to 4.2 percent in just one week. Just the threat of interest rate hikes from the Fed will be enough to delay the recovery in the housing market and labor market. If the Fed decides to start hiking interest rates in the third or fourth quarter of this year, we will likely have to raise our forecast of the U.S. unemployment rate above 6.0 percent before it finds a peak, threatening consumer and business spending well into 2009.

Did it have to come to this? Perhaps. Volcker certainly had to bite the bullet and tolerate an economic recession to tame inflation in 1979. In my mind, the correct monetary policy call needs to rest on one's beliefs about the current oil price shock. Is it a supply shock, or is it a demand shock? Volcker was clearly dealing with a supply shock in 1979 created by the Iranian Revolution and ensuing Iran and Iraq war (1980) that cut global oil supplies and lead to record-high oil prices. This, in turn, created higher unemployment and faster inflation in the United States. The only correct response in that case was to tighten monetary policy to bring prices back under control.

Until recently, the Fed's belief about the current oil price shock rested closer to a demand shock explanation. Previous FOMC statements cited the risks of faster near-term inflation from the spike in oil and commodity prices, but held firm to the belief that inflation would moderate as soon as aggregate demand pulled back with the additional slack in the economy holding back price inflation. If the Fed was lucky, the commodity price and inflation problem would take care of itself without proactive Fed action to slay it, and a deep recession could be avoided.

My sense is that this "Goldilocks" view on inflation and the economy is on the way out. The oil supply shock theory is gaining ground on the FOMC. Crude oil inventories are dropping in the United States, and China stepped up its imports of oil by 25 percent in the wake of last month's earthquake. The beige book release for May reported a new disturbing trend as U.S. manufacturers began passing along their cost increases on up to their customers. Meanwhile, consumer inflation expectations have been significantly unhinged. Our forecast on inflation has increased over the near-term due to such evidence and the renewed spike in oil prices, yet our outlook on the labor market, the credit crunch and growth in 2009 is looking less and less appealing. The May retail sales report was goosed by money illusion and the tax rebate checks. Check under the hood and the fundamental health of the consumer is considerably worse than that number would lead you to believe. I hope for the economy's sake that Federal Reserve Chairman Ben Bernanke's tough talk on inflation expectations and the dollar does the trick in corralling oil prices and inflation, but I have a funny feeling the market is going to test Bernanke's resolve, forcing a cornered Fed to lash out with rate hikes no matter the cost to growth and labor. It is definitely a close call, but I would have waited a little longer for the dust to settle on the credit and housing crisis before I began to pick another fight. The Fed may soon find itself outgunned. There's nothing worse than bringing a knife to a gun battle.

An advertorial submitted by Wells Fargo. Scott Anderson is a senior economist for Wells Fargo. For more information, please visit www.wellsfargo.com.