The Fed's Return to Clarity


By Michael Wallace No surprises from the Federal Reserve this time. At the Aug. 12 meeting of the Federal Open Markets Committee (FOMC), the central bankers decided to hold interest rates steady at 45-year lows and the Fed funds target at 1%. The market reaction was just as muted -- quite a difference from the ruckus in May and June when the Fed introduced a split policy statement tackling economic growth on one hand and price stability on the other.

Chalk that up to a clearer message from Alan Greenspan & Co. This time around, the Fed focused on streamlining the new format for its postmeeting statement in order to iron out any possible confusion. The Fed did make it clear that rates could be held low for a "considerable period." But the success of Greenspan's streamlining maneuver remains to be proven. As sometimes happens, the Aug. 12 statement is more notable for what it doesn't say than what it does.

OPTIMISM RISING. As rumored in advance, the Fed on balance took a slightly more optimistic view of economic developments since the last policy meeting in June. It was noteworthy that the Fed dropped its statement that "the economy has yet to exhibit sustainable growth," which it introduced in June.

Yet there's still a quiver in the central bank's confidence level on the economy: "The evidence accumulated over the intermeeting period shows that spending is firming, although labor market indicators are mixed." That almost seemed a downgrade from "labor and product markets...are stabilizing" in the June statement.

Ironically, Greenspan & Co. also left out the June reference to "markedly improved financial conditions," since yields have backed dramatically higher, and stocks appear to have reached a plateau since June. Also notable by its absence: A dissent from San Francisco Fed President Robert Parry, who bucked the rest of the committee by voting in favor of a half-point rate cut in June.

MINOR ADJUSTMENTS. On the inflation front, the Fed inserted the statement that "business pricing power and increases in core consumer prices remain muted." This came on top of its now-stock statement that "the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level."

The Fed also subtly tweaked its confusing June reference to "that latter concern" (substantial inflation fall). This time, the bankers spelled out the issue: "The risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future." It's clear that disinflation is still Public Enemy No. 1, and the Fed wants to signal it's in a holding pattern, with a bias toward "weakness."

Fed fund futures, a trading vehicle for market pros to bet on the direction of interest rates, rallied with the confirmation that the Fed would keep policy accommodative for the foreseeable future. Even with the price gains, the 2004 futures contracts still imply that the market thinks a rate hike could possibly come as soon as the March 16, 2004, FOMC meeting. In fact, the April contract reflected a 70% likelihood of a quarter-point hike, diminished somewhat from near-90% odds earlier in the session, while the June contract is fully priced for a hike by then.

WIDER SPREAD. Initial market reaction was more constructive for the Fed this time around, with investors appreciating the lack of surprises and the abbreviated statement format. Stocks and the dollar managed healthy, modest gains. Yields on shorter-dated Treasury issues fell sharply as the Fed was taken at its word on keeping rates low. The yield on the 2-year note plunged 10 basis points, to 1.65%.

Things were different, though, on the "long end" of the yield curve. The yield on the 30-year bond actually tacked on 4 basis points, to 5.33%. That resulted in a sharp steepening (nearly 15 points) of the yield spread between 2-year notes and the 30-year bond, to 368 basis points. It's clear that the bond market remains wary of the Fed's zeal to battle any potential for softening prices with "reflation" at a time of fiscal laxity in Washington.

We at MMS International think the Fed is to be applauded for harmonizing and streamlining its views on the economic and inflation risks that lie ahead in an attempt to clarify its very accommodative strategy. Along with recent budget measures, this monetary stimulus should help boost gross domestic product growth to 4.5% in the latter half of the year, in our view.

If the monetary and fiscal pump-priming do their work -- and the economic recovery gains traction -- Greenspan & Co. may be ready to start taking back this "economic insurance" via rate hikes by the second half of 2004. Wallace is a senior investment strategist for MMS International


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