The Fed's Measure of Consistency


By Michael Wallace The Federal Reserve kicked off the current monetary policy cycle exactly a year ago, at a time when the benchmark U.S. interest rate was at a post-World War II low of 1%. The central bank found an appropriate way to mark this anniversary on June 30 by raising the Fed funds target rate a quarter point to 3.25%. All told, Fed chief Alan Greenspan & Co. has tightened by 225 basis points since the series of hikes began.

The decision was unanimous, as usual, with no sign of an obvious rift. As expected, the Federal Open Market Committee, the Fed's policy setting arm, used boilerplate language in the policy statement issued at the end of its two-day meeting.

INCLINED TO HIKES. Crucially, the Fed retained its references to "measured" and "accommodative," thus providing irrefutable evidence that its policy bias leans toward further incremental tightening steps. It's obvious policymakers will continue on such a path until the data suggest otherwise, or the Fed reaches a clear point of policy neutrality.

To drive the point home, the statement concluded that accommodation "can be removed at a pace that is likely to be measured." In addition, "upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal."

As for the economic outlook, the Fed's communiqué noted that although energy prices have risen further, "the expansion remains firm, and labor-market conditions continue to improve gradually." This was an upgrade from "pace of spending growth has slowed somewhat" in the statement from the May FOMC meeting.

MIXED REACTION. Yet, this was only subtly different from the previous version in May, with "expansion" substituting for "spending growth," which had in turn replaced "output" -- small changes and not at all worrisome.

Regarding inflation, the central bank said pressures on prices "have stayed elevated, but longer-term inflation expectations remain well contained." The "stayed elevated" phrase replaced "picking up" in the otherwise identical statement in May. The reference to longer-term inflation expectations was pointedly left in after being mistakenly omitted in the original version in May.

Reaction in the markets was fairly mixed, with prices of shorter-dated Treasury issues falling, and yields rising, as the spread between the 2-year and 10-year notes narrowed to around 28 basis points. That's near the lowest levels of the current Fed policy cycle.

"BOOM-BUST" LINE. By the end of the session, the bond market did manage a small recovery. Equities rolled over into the red, disappointed that there were few signs of a policy pause on the horizon. The dollar was generally mixed vs. other major currencies.

Of course, the Fed's relatively orderly policy outlook depends on just how the economic data play out in the near future, to which the central bank "will respond as needed to fulfill its obligation to maintain price stability."

Some speculation has swirled in the markets that the July 1 release of the Institute for Supply Management's survey of manufacturing conditions in June could come in on the weak side and threaten to breach the "boom-bust" line of 50 for the month -- a point under which the Fed has not tightened historically.

UPSIDE RISK. We at Action Economics

forecast a relatively steady reading of 51.5 for the index, slightly above the 51.4 median forecast of economists and the reported figure for May's level.

Looking forward, the July 8 release of the employment report for June looms large for Wall Street. A recent run of initial unemployment claims figures that came in below market expectations suggests upside risk for growth in the job creation number for June -- above our forecast of 200,000 -- along with a still-low unemployment rate of 5.1%.

Any major divergence from either of these forecasts could alter the outlook on Fed policy into year-end. At Action, we expect the Fed to continue hiking rates in quarter-point steps until it reaches a 4.0% level in November, after which it may pause in December just ahead of Greenspan's expected retirement in January -- and in time to reappraise the economic landscape for 2006. Wallace is global market strategist for Action Economics


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