Nov. 29 (Bloomberg) -- Federal Reserve officials are getting a first-hand lesson in the law of diminishing returns: Try as they might, they can't seem to get the same mileage from their hawkish rhetoric.

In the past few months, every time a policy maker found a waiting platform, he or she used the opportunity to remind us that the Fed is more concerned about rising inflation than slowing growth.

Their words had predictable results. The prices of interest- rate futures contracts that reflect expectations of Fed policy sank, wiping out the gains registered on weak economic data.

The gyrations have been large. The June Eurodollar futures contract rallied 43 basis points from 94.72 on Sept. 18 to 95.15 on Oct. 4. The gains were completely reversed over the next three weeks as various Fed officials -- Fed Governor Don Kohn and District Bank Presidents Michael Moskow (Chicago), Charles Plosser (Philadelphia), Richard Fisher (Dallas) and Jeffrey Lacker (Richmond) -- reiterated their concerns about inflation accelerating or failing to retreat from its current unacceptably high levels.

Then something strange happened. The market stopped listening.

While June Eurodollars have yet to scale their former heights, they haven't revisited their September/October lows in the face of repeated reminders of the risks of inflation from the Fed. The June contract is priced for a full 25-basis-point rate cut and part of a second by mid-year -- even after Fed Chairman Ben Bernanke's comments yesterday that inflation risks are ``primarily to the upside.'' In a world where the next Fed move will be based on the cumulative weight of the evidence (data), Mr. Market is saying he knows best.

Inflation Reality

To be fair, a dose of inflation reality intervened to challenge the Fed's fears about higher inflation. The core consumer price index, which excludes food and energy, rose 0.1 percent in October, the smallest increase in eight months. The year-over-year increase fell 0.2 percentage points to 2.7 percent, also the first drop in eight months.

The energy-driven CPI rose 1.3 percent in October from a year earlier, down from more than 4 percent as recently as July.

One month does not confirm a trend, but the improvement was enough to reassure the market and give weaker economic data the upper hand.

Yesterday's report of a 5.1 percent drop in orders for non- defense capital goods excluding aircraft, the biggest decline since January 2004 for this indicator of future capital spending, was another coffin nail in the optimistic investment outlook.

Investment Outlook Dimming

``We have always been skeptical of the idea that capital spending would charge on regardless of the rest of the economy,'' said Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, New York, in a note to clients. ``These data support our view.''

While durable goods orders are volatile on a month-to-month basis -- non-defense capital goods orders excluding aircraft rose 3.2 percent in September -- the year-over-year increase has fallen to 7.2 percent from a peak of almost 20 percent in January 2005.

This wouldn't be the first time that traders and investors have chosen to challenge the Fed's forecast, if you can call its risk assessment that. (No doubt the hawkish rhetoric was geared in part toward containing inflation expectations, which seem to garner as much weight as actual inflation.) And on some level, Fed Chairman Ben Bernanke must be smiling.

One of the reasons he's such a strong advocate for adopting an explicit inflation target is to make the central bank more transparent. In a perfect world of central bank transparency, investors respond to news, not to what policy makers say.

Detachment

A defiant bond market, whose risk assessment is for a weaker economy and a reduction in the overnight rate, is both a sign of success -- the price action has detached from Fedspeak -- and a source of information. If the bond market merely reflected what Fed officials said, then they have achieved a perfect feedback loop, with zero informational content.

As it is, the yield on long-term Treasury notes and bonds reflects the price at which borrowers (the U.S. government) and lenders agree to transact business. The invisible hand sets the equilibrium price.

The Fed, on the other hand, arbitrarily picks and maintains an interest rate at which banks can make uncollateralized overnight loans to one another. Its ``guesstimate'' of the appropriate federal funds rate is submitted, each and every day, to the market for its approval. Is the funds rate too high, too low or just right?

TXT MSG

The current inverted shape of the yield curve, with long rates lower than the funds rate, reflects the bond market's view that short rates are unsustainable at this level. November will be the fifth consecutive month the spread is negative. Yesterday the yield on the 10-year Treasury note slipped below 4.5 percent for the first time since January.

Does the market know something the Fed doesn't know? It usually does. Bernanke may be smiling, but on some level, he has to be concerned about the message he's receiving loud and clear.

Market to Fed: I hear you. I respectfully disagree.

(Caroline Baum, author of ``Just What I Said,'' is a columnist for Bloomberg News. The opinions expressed are her own.)

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: November 29, 2006 00:12 EST