The dollar has been underpinned of late as a result of growing expectations of an impending rate hike by the Fed. This morning's much better than expected retail sales number served to heighten those expectations.

Retail sales for May grew by 1.0%, about twice what the market was looking for. Much of the gains in retail sales are going to be attributed to the economic stimulus package, raising the question of sustainability. Now the question becomes; will the US consumer continue to buy after having spent their stimulus checks?

Nonetheless, the Fed now has a little breathing room to address the inflation issue, which has gotten so much play this week.

The Fed is expected to hold steady on Fed funds at 2.0% at the 24/25-Jun FOMC meeting. However, there is a growing rumble that they may move to widen the spread between Fed funds and the discount rate back to 50bp.

You may recall that the Fed made an intra-meeting move to lower the discount rate by 25bp on 16-Mar, narrowing the spread with Fed funds to just 25bp. Two days later, at the scheduled FOMC meeting, the Fed cut both Fed funds and the discount rate by 75bp.

On the back of the strong retail sales data, Fed funds now place the odds of quarter point tightening in Aug near 70%. Further out, a half point hike to 2.50% is now fully priced in for the 29-Oct FOMC meeting.

Here's the Fed's conundrum: The Fed's very own Beige Book (released just yesterday) described business conditions as "generally weak" and manufacturing as "generally soft." Today's retail sales surprise notwithstanding, the US economy seems far from recovery.

While inflation is certainly a very real concern, launching a tightening cycle now is going to increase risks to growth and would threaten to exacerbate the ongoing credit crisis.

If the Fed begins raising rates and the economy begins to slide, can they reverse course and start easing again? I would argue not, or the Bernanke Fed risks losing any credibility that it has. Reactive monetary policy is unpredictable monetary policy and the markets don't like unpredictable.

Given all the expressed concerns about inflation this week, the Fed is probably obligated to do something a little more substantive than talk. To do nothing beyond the incessant jawboning would likely lead to a rather precipitous reversal of the recent dollar gains.

And what of those American consumers that dutifully went out and spent their stimulus checks? How will they react to higher interest rates?

Again one must look no further than the Fed's own data. Last week the Fed released US household net worth data for Q1, which posted a decline of $1.7 trillion or 2.9%. This was the second consecutive quarterly decline and the largest in five years. In nominal annualized terms, that's a pace of -11.3%.

For most households the home itself is the key asset. Homeowners' equity tumbled to 46.2%, the lowest level since the end of World War II. Q1-08 also marked the fifth consecutive quarter where homeowners' equity was below 50%.

In a speech last week, Fed Chairman Bernanke summed it up nicely, saying, "Households continue to face significant headwinds, including falling house prices, a softer job market, tighter credit, and higher energy prices. Until the housing market, and particularly house prices, show signs of stabilization, growth risks will remain to the downside."

Having acknowledged the growth risks, particularly to housing, just last week the emphasis on inflation this week sends a confusing signal. We have suggested in previous commentary that this may in fact be the goal.

When Bernanke first took the reigns of the Fed, a new era of transparency was anticipated. Bernanke may have finally realized there are benefits to sending mixed signals ala Alan Greenspan.

Keep in mind that despite the dual mandate of price stability and sustainable economic/employment growth, the Fed tends to err toward the latter.

Also keep in mind that the present economic crisis ultimately comes back around to housing. A shift to a tighter monetary policy is not going to do any favors for the vulnerable housing market. In fact, the national average for a 30-year fixed rate mortgage has surged to 6.20% this week, a new high for the year. For that reason alone, a true policy shift seems unlikely at this point.

A hike in the discount rate would signal that the Fed is at least marginally reacting to growing price risk without completely ignoring that substantial risks to growth remain.

This may allow the dollar to hang on to at least some of its recent hard-won gains, but tests in the dollar index above 74.00 seem unsustainable.

With the low end of the range in gold intact, buying opportunities remain highlighted. A rebound above 882.15/85 would bode well for renewed short-term tests above 900.00.

Gold Market Movers:

US business inventories for Apr +0.5%, sales surge 1.4%.

US retail sales for May +1.0%, about twice what the market was expecting.

US initial jobless claims for the week ended 07-Jun +25k to 384k. A bigger jump than was expected.

US import prices surge 2.3%, near expectations.

Eurozone industrial production +0.9%, much better than the market was expecting.

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