Fed funds futures continue to show serious expectations of a rate hike, possibly as soon as Aug. Odds of a 25bp hike to Fed funds in Aug are presently about 66%. As recently as last week, the market consensus was that the Fed was unlikely to raise rates before Dec.

However, the rising specter of inflation seemed to galvanize the financial powers-that-be in Washington this week; eliciting anti-inflationary/dollar supportive comments from Fed Chairman Bernanke, Treasury Secretary Paulson and the President himself.

This coordinated jawboning caught the markets a little off-guard, prompting what was at least initially a short-covering rally in the greenback. The dollar index has now moved more convincingly above 74.00, but I still don't believe these gains are sustainable.

I do think the consolidation range has been shifted higher as a result of tightening expectations. The DX is now likely to trade in the 73.14/74.91 range ahead of the 24/25-Jun FOMC meeting. While the Fed is expected to hold steady on rates this month, focus will be on the policy statements for clues as to what's ahead for the remainder of the year.

Despite what Fed funds futures are telling me, I have a hard time believing that the Fed is on the verge of initiating a tightening cycle. With considerable risks to growth still evident, raising rates now will effectively take the possibility of a future rate cut off the table as a means to stimulate the economy if things take a turn for the worse down the road.

The Fed must be either be easing, tightening or steady. They can not raise rates one month and lower them the next without undermining their own credibility. I've said it before and I'll say it again: Reactive monetary policy is unpredictable monetary policy and the markets don't like unpredictable.

Yet we do have some degree of unpredictability going on already. Chairman Bernanke highlighted persistent risks to growth in a number of speeches just last week and this week it's been all about price risks.

Gold has been holding up pretty well in the face of the recent dollar gains. To some degree I feel that it is the uncertainty fostered by the mixed signals of late that have been supporting gold. Gold is afterall the classic hedge again economic uncertainty.

In reality the significant economic risks and inflation are both supportive to the gold market. How the Fed decides to deal with one or both of these issues is going to determine the short-term price action in the dollar and gold. However, the Fed has historically placed greater emphasis on sustainable economic growth and employment.

It is simply more likely that the Fed will let inflation continue for some period, presumably while they focus on stabilizing the economy. Fed Vice Chairman Donald Kohn said as much at a conference sponsored by the Boston Federal Reserve Bank on Wednesday.

"It may be efficient to allow some adjustment period in which both overall inflation exceeds its desired low level and the unemployment rate is higher than its long-run sustainable level...setting policy in a manner that balances the undesirable effects of a shock to the system on both inflation and employment will tend to be more efficient than setting policy so as to deliver more extreme outcomes in either inflation or unemployment," remarked Mr. Kohn.

Recent downgrades to the monoline insurers portend further write-downs in the banking sector. Persistent concerns about further fall-out from the huge credit derivatives market are still apparent as well.

That means that the credit crisis is probably far from being over and Fed liquidity facilities will continue to be accessed, and may even have to be expanded. That money needs to come from somewhere and expansion of the money supply is the logical source. Raising interest rates while simultaneously expanding the money supply is a little counterproductive.

Tighter monetary policy also drives up mortgage rates, resulting in a negative impact on demand in the housing market. The average 30-year fixed rate mortgage set another new high for the year today, climbing an additional 9bp in just the past day.

With American homeowners already reeling from considerable erosion to their net worth, the risk is a further reduction in consumer confidence and spending. That would in turn threaten the broader economy and jeopardize any hope of a soft landing and short-term recovery. Again, a pretty compelling reason for the Fed not to start hiking rates.

Gold Market Movers:

U Michigan consumer sentiment index slid to 56.7, well below market expectations, versus 59.8 in May.

US CPI for May +0.6%, above market expectations. Core +0.2%.

Eurozone labor costs for Q1 +3.3% y/y, above market expectations.

German final HICP inflation revised up to 3.1% y/y from 3.0% y/y.

BOJ holds steady on policy rate at 0.5%, as expected.

US inflation soars on rise in energy

Corn up 20% over seven futures-trading sessions

Inflation fears may push gold back to $1,000

The short view: Stagflation