The Fed Hedges, Citing Housing Woes

Bernanke & Co. kept rates unchanged on Dec. 12, but kept its options open by noting cooling in home prices and "mixed" indicators

by Michael Wallace

Steady as she goes for Ben Bernanke & Co. The Federal Reserve stuck to its guns at its Dec. 12 policy meeting and held the Fed funds target rate at 5.25% for the fourth consecutive meeting, while retaining the tightening bias that has been implicit in their policy statement to round out 2006.

However, the Federal Open Market Committee, the central bank's rate-setting arm, did fine-tune its reading on the economy to reflect what its members now consider to be "substantial" cooling of the housing market and "mixed" recent economic indicators. This appears to be a hedge against their core forecast of a moderate expansion. Those adjustments provided a narrow opening for those still calling for a rate cut early next year.

The Fed began the year with a quarter point hike to 4.5% and followed with three additional hikes before leveling off in June—a cumulative 425 basis point tightening for the cycle in just over two years. All the while, the Fed has maintained its vigil against inflation expectations taking root and, barring a "smoking gun" (like an adverse financial event in the mortgage or auto sectors), the central bank still appeared set against a policy reversal. Yet when the Fed finally took its foot off the rate-hike pedal in August, the pause was viewed by many as a concession to bond-market participants with a more pessimistic view on the economic trajectory.

Inflation Fears Moderating

As such, the sideways trend in short-term interest rates has translated to a 75 basis point drop in long-term bond yields, amid fear of broader contagion from the weak housing sector. Recent foreclosures on two subprime mortgage lenders raised the stakes another notch ahead of the meeting.

Otherwise, the Fed's Dec. 12 statement was substantially identical to its previous version. It characterized core inflation as still "elevated" and warned of high levels of resource utilization, with potentially sustained inflation pressures.

However, Bernanke & Co. continue to foresee inflation pressures moderating ahead, given contained inflation expectations, reduced pressure from energy prices, and the cumulative impact from monetary policy. The board's úber-hawk, Richmond Fed President Jeffrey Lacker, continued his advocacy of a quarter-point rate increase by casting the sole vote against the Fed's Dec. 12 decision.

Muted Reaction

In the statement, the FOMC began its economic outlook innocently enough, referring to slowing growth over the year, but noted this time that the outlook partly reflected "a substantial" cooling in the housing sector. It also conceded that recent economic data had been "mixed," while standing by its assertion that the economy is expected to expand at a moderate pace "on balance over coming quarters." It's too soon to judge these changes as a sign of rate cuts to come, but they clearly suggest that the Fed remains finely balanced between its mandate to foster sustainable growth and contain inflation.

Specifically, the "mixed" data rebalanced in the Fed's favor after the Institute for Supply Management's November non-manufacturing index rebounded to the strongest level since May, and the employment report in November came in stronger than expected. This offset weakness in November's Chicago purchasing-managers and ISM manufacturing surveys, which slipped below the 50.0 boom-bust line for the month and briefly boosted market sentiment in favor of a first-quarter rate cut from the Fed.

The Fed's Dec. 12 decision was very well discounted by financial markets thanks to recent verbal guidance from Fed officials and the recent firming in employment data, though the statement's altered tone on the economic mix indicated some equivocation on the economy creeping in. Market reaction was relatively muted upon first read of the statement, but bond yields edged marginally lower as the details revealed rising concern over the housing sector and the mixed tone on recent economic data. The dollar followed U.S. yields lower on Dec. 12, but major equity indexes rebounded from session lows as the Fed appeared somewhat less intransigent over the economic outlook.

Always Vigilant

Fed funds futures, a vehicle for market pros to bet on the future direction of interest rates, finished the day marginally higher, taking the mention of "substantial" housing weakness largely in stride. The odds of a quarter-point rate cut by the first quarter of next year accordingly edged up to 35% from 32% ahead of the decision. That said, the futures are fully priced for a rate cut by the June meeting, with July Fed funds trading near a 5% equivalent yield. That will raise the stakes at the next monetary policy report from the Chairman—scheduled for February—if a stronger signal is warranted by then.

The statement's penultimate paragraph on the tightening bias was boilerplate, reiterating that "some inflation risks remain" and "any additional firming" will be dependent on future data reports. That was the signal that the FOMC sees remaining on duty against inflation as its primary goal, and isn't poised to cut rates as soon as the next meeting, based on its view that the economy should work its way through this soft patch and return to its trend growth path in 2007.

The Fed's rhetorical footwork will buy it time until the New Year to get fresh readings on the economy as it makes ready to set its policy compass again in the first quarter.

Wallace is global investment strategist for Action Economics.