The Fed stood pat on rates even as the economy appears poised for the strongest sustained growth since the recession ended. Indeed, the central bank forged ahead with its cumbersome dual-policy statement -- which evenly split the outlook for economic growth and price stability -- a signal that it won't be ready to remove its accommodative policy stance "for a considerable time."
PINK-SLIP BLUES. The FOMC opted to keep the new policy statement nearly identical with its Aug. 12 predecessor. Indeed, the statement issued after the Sept. 16 meeting repeated by rote the roles of accommodative monetary policy and robust productivity in providing a solid foundation for the economy.
Contrary to the forecast by some Fed-watchers that the central bank would ratchet up its expectations for growth, however, Greenspan & Co. indicated that the labor market remained the economy's Achilles' heel. "The evidence accumulated over the intermeeting period confirms that spending is firming, although the labor market has been weakening," the second paragraph of the statement said.
That's somewhat of a contrast to the Aug. 12 statement, when the FOMC said labor-market indicators were "mixed." The semantic shift appeared to accommodate the unexpectedly high 93,000 drop in nonfarm payrolls in August -- and the recent run of weekly initial-jobless claims averaging well above the 400,000 level, which suggest job-market conditions remain weak.
MARKET REACTIONS. Significantly, the Fed otherwise stood by its balanced assessment of the economic risks going forward, while sustaining its view 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 reiterated that the "risk of inflation becoming undesirably low remains the predominant concern for the foreseeable future." Underscoring that point, it repeated its intention to maintain an easy policy stance for a "considerable period."
The bond market's reaction to this tellingly repressed statement was understandably bland -- which makes it a resounding success by recent Fed standards. Fed fund futures, a trading vehicle for market pros to bet on the future direction of interest rates, indicated virtually no chance that the Fed will hike before February, 2004. In fact, it isn't until July, 2004, that the futures market fully reflects the risk of a quarter-point rate hike, to 1.25%. The comparable euro-dollar contract pegs the benchmark rate at 1.5% by then.
Treasury prices initially moved a bit higher in reaction to the statement, especially after the upgrade to the Fed's growth outlook conjured by some market observers failed to take place. But the stock market brushed aside the FOMC's rhetorical subtleties and extended earlier gains. The strength in equities helped push bonds back to unchanged levels by the close, but sustained the impulse toward a steeper yield curve -- the spread between rates on the 2-year note and 10-year bond. The dollar initially weakened, but finished higher vs. the euro and yen.
EYES ON '04. We at MMS International expect that the Fed's accommodative position will be increasingly difficult to maintain heading into 2004 amid an improving economy, though its vigilance on deflation can probably be maintained at least through the end of this year. With growth set to surge above a 6% annual rate in the last half of 2003 -- and to average 4.5% in 2004 -- we expect the Fed to begin to take back some of its historic string of rate cuts by the middle of next year.
The key is just how quickly the markets move from pricing in this risk to getting ahead of the policy curve. Another move higher in Treasury yields late in the year could either be a vote on Fed credibility or the improving economy. The bottom line for the Fed: It would be wise to keep policy options open for the "foreseeable future." And the Fed's track record on staying flexible seems pretty solid. Wallace is a senior market strategist for MMS International