How the Fed could spook the markets

Clearly, not much can rattle investors these days. They have so far shrugged off the threat of a sectarian civil war in Iraq and the risk of crude oil flows getting disrupted. Not even a re-escalation of tensions between Moscow and Kiev over natural gas prices has moved the needle.

Much of this is due to the warm, fuzzy feeling folks are getting from the Federal Reserve, which continues to pump cheap money stimulus into the economy despite the fact industrial production has eclipsed its 2007 peak, the overall unemployment rate is dropping fast and the short-term unemployment rate has fallen to levels not seen since the 1970s.

In fact, inflation-adjusted interest rates haven't been held this low this long since the 1970s -- an experiment in money-printing that resulted in two recessions and 20 percent-plus interest rates after the Iranian oil shock.

That could change on Wednesday as the Fed wraps up its latest two-day policy meeting. The Fed is widely expected to taper its ongoing "QE3" bond-purchase program by another $10 billion, to a $35 billion per month rate, and is on track to end the program in October.

But two things could rattle investors: If the Fed acknowledges the recent rise in inflationary pressures and it moves up of the timing of its first short-term rate hike.

New Fed chairman Janet Yellen had a rocky start earlier this year when she suggested in March that short-term interest rates could be raised in the early part of 2015 -- whereas the market has been expecting action toward the back half of the year. Wall Street consternation was also high over a similarly hawkish takeaway from individual Fed policymakers' estimates on the course of interest rates.

Known colloquially as the "dot plot," these estimates reinforced the notion that short-term rates could be raised sooner than investors had expected.

Since then, Yellen and the Fed have been busily trying to walk back those expectations. Yellen in particular has been trying to find new justifications to support the continuation of the Fed's near-zero-percent policy, including a lack of wage growth and a depressed labor participation rate.

What's changed is inflation, with the consumer price index expanding at a 2.1 percent annual rate last month as food prices swell (chart above). The three-month annualized inflation rate is up to 2.8 percent. No wonder consumer confidence and retail sales have been soft lately. But it's not just food and fuel prices that are pinching pocketbooks. Higher prices are being seen in areas like shelter/rent costs, health care and services like airlines and hotels.

Not every Federal Reserve policy announcement features a press conference and a dot plot. But Wednesday's does.

Yellen will have a tough time not acknowledging the increase in inflation, the tightening of the labor market and the obvious conclusion that to avoid a more serious rise in prices, interest rates need to start creeping higher sooner rather than later. She could also outline in more detail how the Fed plans to normalize the monetary base, which has swollen from $800 billion to more than $4 trillion now.

In doing so, investors will have to face the reality that within the next year, for the first time since 2008, borrowing short-term money will no longer be essentially free. As a result, many of the assumptions that have lifted both bond and stock prices in the years since then will be challenged as the Fed prepares to embark on its first monetary tightening campaign since 2004.