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Alan Greenspan has to be smiling today. When the Federal Reserve rejigged the way it communicates with the markets in January, it was hoping to avoid the perverse effects that accompanied its interest-rate hikes last year.
Rather than falling in response to higher borrowing costs, the stock market rallied in the wake of Fed rate hikes in June and November. The markets took false hope that the central bank was done raising rates for a while. That complicated the Fed's efforts to cool down the red-hot economy because the higher stock prices boosted consumer confidence and spending.
But based on the stock market's reaction to the Fed's Feb. 2 quarter-percentage-point rate increase, the central bank's new communication policy seems to be working. After being up about 60 points just before the Fed's midafternoon announcement, the Dow Jones industrial average fell to end the day down more than 35 points. Contrary to the confusion that greeted some of the Fed's announcements last year, experts say the central bank's latest pronouncement left little doubt as to where interest rates are headed -- up. "There are more rate hikes to come, unless demand slows," says Neal M. Soss, chief economist at Credit Suisse First Boston. "It was a successful outing in terms of communication."
TREASURY RALLY.
The reaction in the government bond market was more complicated. Treasury's announcement on Feb. 2 that it was cutting back on the amount of debt it's issuing buoyed bond prices, despite the Fed's rate hike. On its face, the rally in the Treasury market would seem to threaten the Fed's efforts to slow the economy down by lowering long-term interest rates. But many analysts believe that the fall in Treasury bond yields won't be matched by a commensurate decline in rates on corporate bonds or home mortgages.
The Fed's new disclosure policy did away with its so-called bias announcements that tried to let the markets know which way the central bank was leaning on interest rates. Those announcements caused more confusion than clarity because it was unclear what time frame the statements covered. Did a "neutral" stance mean Fed policy was on hold just until the central bank's next meeting, or beyond?
In an effort to clarify things, the Fed now simply tells the markets where it thinks the risks to the economy lie -- in the direction of higher inflation, slower growth, or somewhere in between. That assessment applies to the period up to the next meeting and beyond.
BROKEN SPEED LIMIT.
In its rollout of its new communication strategy on Feb. 2, the Fed said "the risks are weighted mainly toward...heightened inflation pressures in the foreseeable future." It also said that it remained concerned that the economy was growing too fast for its own good. You can say that again. In a preliminary assessment on Jan. 28, the Commerce Dept. said the economy grew at a 5.8% annual rate in the fourth quarter of 1999. Experts say data released since then suggest that growth may have even topped 6% -- well above the Fed's presumed speed limit of about 3.5%.
Fed watchers say the only question left unanswered by the central bank's latest announcement was how much it will raise rates at its next meeting, on Mar. 21. Will it stick with what Wells Fargo Chief Economist Sung Won Sohn calls its "slow-motion monetary policy" and raise rates by only a quarter-percentage point? Or will it get more aggressive and jack up rates by a half-point?
Arguing for the latter course: a rip-roaring economy that shows scant signs of slowing in response to the Fed's repeated taps on the monetary brakes. Arguing for continued restraint: still-benign inflation, continued strong productivity growth, and perhaps most important, a stock market that finally seems to be understanding what the Fed is up to.
If the stock market continues to cooperate and the Fed's new communication policy keeps working as well as it did on Feb. 2, the central bank may be able to stick with its drip, drip, drip approach toward raising rates and avoid the sharp, prolonged hikes that some investors fear.
By Rich Miller and Laura Cohn in Washington EDITED BY DOUGLAS HARBRECHT
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