The Fed's Clearly Opaque Message


By Michael Wallace Alan Greenspan & Co.'s streak has reached 10 -- and counting. On Aug. 9, the Federal Reserve matched widely held expectations for a tenth consecutive quarter-point hike in the Fed funds target rate to 3.5%. Policymakers have lifted the benchmark rate 2 percentage points from its more-than-four-decade low of 1% in just over a year.

If there was any new slant in the post-meeting statement issued by the Federal Open Market Committee, the central bank's policy-setting arm, it was decidedly cryptic.

SUBTLE TWEAK. The standard message that policy remains "measured" and conditions still considered "accommodative" left it clear that the Fed intends to telegraph any more drip-feed rate hikes to come. Those hoping for hints at an accelerated pace of tightening were broadly disappointed.

The Fed tweaked its previous reference to the economic "expansion" to refer to "aggregate spending," which "appears to have strengthened since late winter," notwithstanding high energy prices. Previously, the "expansion remains firm" was the catch phrase for growth.

This could be taken as a slight upgrade to growth prospects, given the healthy run of data that emerged over the period since the FOMC's June 30 meeting. With this revision, the Fed is both acknowledging the stronger economic data of the past six weeks, and is positioning itself for additional strong reports over the months ahead.

INFLATION WATCH. The spending reference is unlikely to be the last in a series of synonyms used by the FOMC to bide time until the Fed reaches policy neutrality -- where rates are neither too stimulative nor too inhibitive of growth. Past entries have included the aforementioned "expansion," as well as "spending growth" and "output." The Fed's characterization of labor market conditions -- that they continue to "improve gradually" -- was left intact from June.

The committee's reference to inflation appeared slightly more intriguing than the one on spending, suggesting that "core inflation [excluding food and energy prices] has been relatively low in recent months and longer-term inflation expectations remain well contained, but pressures on inflation have stayed elevated." This seems more expansive compared to June's "pressures on inflation have stayed elevated, but longer-term inflation pressures remain well contained."

The qualifier appeared to be that the Fed is a little more comfortable on the behavior of core prices, despite elevated energy costs. This has also been borne out in recent economic reports. We will get another glimpse at core inflation reports in mid-August with the release of the consumer and producer price indexes for July, which we expect to corroborate the Fed's view.

EASING YIELDS. The juxtaposition of a slightly firmer outlook on growth prospects with seemingly greater comfort with performance of core inflation proved a wash for the markets. For the bond market, the statement instilled some confidence that even if the Fed continues the tightening cycle longer than previously expected, it will do so gradually, all else being equal. Of course, the FOMC retained the right to "respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability," but otherwise the balance of risk on sustainable growth and price stability remained "roughly equal" after this policy action.

Market reaction on Aug. 9 was cautiously optimistic, with bond yields finishing roughly where they began the session after a defensive run-up ahead of the statement, on fear that something more hawkish might emerge. The 10-year yield slipped back to 4.4% after setting a 4-month high of 4.43%, while the 2-year yield pulled back from a 4-year high near 4.18%. Already cheered by a report earlier in the day showing a dip in second-quarter unit labor costs, as well as a pullback in crude oil prices from record highs, and M&A activity ahead of the FOMC meeting, stocks finished with gains.

The recent round of solid payrolls gains in July reinforced the pattern evident in most of the other major monthly indicators that the economy is now "making up for lost time" following the impact of business caution on inventory management in response to market "soft patch" fears (see BW Online, 8/05/05, "The Jobs Explosion").

EYE ON JANUARY. We at Action Economics

maintain our outlook that U.S. gross domestic product will expand at a 5% clip in the third quarter, with only slightly more subdued average rates of around 4% going forward, with additional risk that second-quarter gross domestic product growth will be bumped higher from the advance 3.4% estimate.

The combination of the latest FOMC statement and the trajectory of recent economic and inflation data suggest to us that the Fed will continue to snug up interest rates through at least the end of Chairman Greenspan's term in January. We expect the benchmark rate will be at 4.5% by the time the central bank delivers its semiannual economic update before Congress in February. Wallace is global market strategist for Action Economics


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