The Fed: Suddenly, This Summer?


By Michael Wallace Alan Greenspan got a chance for a "do-over" one day after financial markets slumped on the Federal Reserve chairman's remarks before the Senate Banking Committee, which Wall Street interpreted as a signal that an interest rate hike may come sooner than later. In testimony before the Joint Economic Council (JEC) of Congress on Apr. 21, the Fed chief had ample opportunity to alter market perceptions.

However, Greenspan didn't change his tune, sticking more or less to his message from the previous session. He remained upbeat on the "more vigorous expansion" and suggested that rates would have to head higher "at some point," though he reminded lawmakers and investors that broad-based inflation wasn't yet an immediate threat.

NO MORE PATIENCE. Greenspan didn't pin down any particulars of what the Fed will do or when. But we at Action Economics believe the upshot of his Apr. 20-21 testimony to be that the Fed's policy bias could be adjusted as early as May 4, at the next meeting of the Federal Open Market Committee, the Fed's policy-setting arm, though the central bank wouldn't likely consider raising rates until its Aug. 10 meeting.

In the months ahead, we expect the Fed to alter its "split" assessment of economic conditions for both economic growth and inflation. The policy outlook will probably shift in favor of a greater likelihood of strengthening, vs. weakening, growth. As for price stability, we think the central bank will continue to deemphasize the threat of deflation as more evidence of an inflation upturn emerges. Note that in the two days of April testimony, Greenspan made no reference to the Fed's willingness to be patient on its policy stance, which suggests the "patience" phrase will be dropped from Fed policy statements in coming months.

In his Apr. 20 Senate appearance, the central banker alluded to the potential for higher rates, expressed confidence in the economy, dismissed the deflation threat, and said corporate pricing power was recovering. He also suggested that the banking community could, by and large, handle a rise in interest rates.

UNUSUALLY LOW INFLATION. Financial markets reacted swiftly and negatively to those statements. Stocks slid on Apr. 20, with the Nasdaq composite index falling 2.1%. The bond market, which has been acutely sensitive of late to any hint of higher rates, sold off -- with short-term yields rising sharply. But when asked about whether the markets' reaction was "correct" during the JEC testimony a day later, Greenspan was coy: "I don't know."

Cross-examination from the JEC panel during the Q&A session that followed the Apr. 21 testimony was a tad more aggressive than at the previous appearance. Senator Paul Sarbanes (D-Md.), in particular, tried to pin down Greenspan on a timeline and trajectory on interest rates ahead. The chairman provided artfully indirect answers. When pressed, he indicated that "on average" rate cycles lasted only "a year or so" but would not be drawn to reveal the Fed's current time frame or ultimate rate target.

Quite simply, the Fed likely hasn't made these decisions yet. It wants to study economic data available between now and the next time the FOMC meet.

LINGERING "SLACK." Greenspan did agree that the current low level of inflation was "unusual" and likely the result of forces such as globalization and productivity, commenting that the Fed's ultimate goal was "price stability." He acknowledged the last episode of severe rate hikes in 1994 that roiled the bond market back then (and the memory of which has been lately haunting the markets). But he noted that the markets are much better equipped to hedge such risks today.

On the more dovish side, he did still see lingering "slack" in the business community and expected the general price level to remain tame "for a while."

In terms of policy, the last paragraph of Greenspan's written JEC testimony spelled the risk of higher rates fairly succinctly. He noted that the Fed funds rate must rise at some point to prevent pressures on inflation from eventually emerging. The chairman said the protracted period of monetary accommodation had not yet fostered an environment in which broad-based inflation pressures appear to be building. But the Fed "recognizes that sustained prosperity requires the maintenance of price stability and will act, as necessary, to ensure that outcome."

TICKING CLOCK. Since Greenspan thoroughly previewed his testimony the day before in the Senate, market reaction was minimal, though bond yields remained elevated, and the stock market turned in a mixed performance (the Dow Jones industrial average was lower, while broader indexes moved slightly higher). The dollar stabilized vs. other major currencies after the previous session's rise. Three-month eurodollar interest rate futures, a trading vehicle used by market pros to bet on future rate moves, fell in price while the chairman spoke and now imply a rise in the Fed funds rate by August, from the current multidecade low of 1%.

All in all, the combined testimony suggests that the policy clock is now ticking on the Fed to embark on a tightening cycle ahead of the November election. Nonetheless, Greenspan & Co. will wait for more evidence to emerge on the economic and inflation fronts before making a final decision to hike. Once that cycle begins, however, the Fed may be in no particular hurry to act aggressively, unless inflation rears its head. Wallace is global market strategist for Action Economics, based in San Francisco


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