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U.S.: From Here On Out, The Fed Is Winging It


The Federal Reserve's first policy decision under new chairman Ben S. Bernanke was, as expected, a no-brainer. The Fed lifted its target interest rate on Mar. 28 by a quarter-point for the 15th time in the past 15 meetings, to 4.75%. The post-meeting statement included a bit more detail on economic activity, but the key policy-related remarks were carbon copies of the Jan. 31 missive. In all, it was an obvious display of the greater transparency and continuity that Bernanke has promised.

Now it gets interesting -- for both the markets and policymakers. Up to this point, judging Fed policy has been easy. Back in June, 2004, the Fed essentially told the markets it was going to lift its target rate from a 46-year low of 1% that was highly stimulative to economic growth to a more neutral level historically consistent with healthy growth and low inflation. Until now, the patterns in the economic data played only a small role in the Fed's game plan. That phase is over.

There is no more road map for the markets to follow. Policymakers' Job 1 is to decide whether the current target rate of 4.75% is high enough to assure that inflation will stay under control in the coming year. Not only do the markets not know what the Fed's next move will be, the Fed itself doesn't know. That means much more uncertainty surrounding future Fed actions, and more uncertainty means greater volatility.

Market reaction immediately following the Fed's Mar. 28 hike is a case in point. Stock and bond prices sank over disappointment that the Fed did not hint that the end of its tightening cycle was near. On the contrary: The Fed repeated its Jan. 31 language, saying that "some further policy firming may be needed." The Dow Jones industrial average suffered a 110-point turnaround after the news, and 10-year Treasury yields, which had begun the day at 4.71%, finished at a 22-month high of 4.78%. More days like that appear to be in store as the Fed gropes its way toward the right policy.

HOW WILL THE FED KNOW when its work is done? The basis for that decision now shifts almost exclusively to the economic data. The next action or inaction will depend on how the policymakers interpret what each new squiggle in the charts means for the trends in economic growth and inflation. The upshot: Each economic report will take on increased significance for the markets, especially for bonds, over the balance of the year. Data surprises, particularly any that suggest stronger growth and more inflation, may pack more of a punch than they have up to now.

What signposts will the Fed be looking at? Of course, policymakers will say they consider everything. But three broad classes of data will probably command the Fed's attention. Readings on core inflation, which exclude energy and food, will show whether higher energy costs are working their way into the prices of other items. Labor-market data will indicate whether wage and salary increases are outstripping productivity gains. And housing activity will be a key bellwether, given its past importance to overall growth and consumer spending.

Right now all three are sending fairly positive signals to the markets, suggesting the Fed might need only one more hike, to 5%, at its May 10 meeting. Policymakers undoubtedly take great comfort in how the price indexes are behaving. Despite the two-year runup in energy prices, current core inflation readings at the consumer level show not the slightest hint that costlier energy is pushing up other prices. The core consumer price index (CPI) in February stood only 2.1% ahead of its year-ago level, and the Fed's preferred inflation gauge, the core index for personal consumption expenditures (PCE), is slightly below 2% and has been edging lower.

In coming months, any higher-than-expected readings in the price indexes hold the greatest potential to rattle the markets, for two reasons. One, they would suggest that the Fed is lagging in its efforts to control inflation. And two, current inflation rates tend to influence people's expectations of future inflation, which can feed back into pricing behavior and become a vicious cycle.

BUT EVEN IF THE PRICE INDEXES remain tame, the Fed will also keep a keen eye on the strength of the economy. Labor markets are stretched thin, and the ability of industrial and service companies to meet demand is being tested. If the economy does not give convincing signs of cooling off in a way that will relieve these pressures, the Fed may feel the need to push its target rate north of 5%.

Perhaps the most difficult task for the Fed this year will be correctly interpreting the interplay between improving labor markets and slower housing. Both will influence consumer spending, but in opposite ways. The view in the markets right now is that the housing slowdown will dampen consumer spending, as outlays for home-related goods wane and consumers stop using the equity in their homes as a source of income for spending.

The housing downdraft is clearly under way (page 68). In February sales of new homes were down 21% from their peak last July, while sales of existing homes are off 5% from their high point last June. Further weakness seems likely. The new-home and condominium markets, where activity has been especially frothy with high turnover, could take the biggest hits in terms of both building activity and prices. Inventories of unsold new homes in relation to recent sales rates have jumped to the highest level in ten years, suggesting a growing imbalance between supply and demand.

THE KEY QUESTION for future Fed decisions is this: How much will housing slow consumer spending? The answer will depend mainly on the health of the labor markets. The combination of improving income growth and past wealth gains, less than a third of which came from net home values last year, will help to offset housing-related losses to spending power.

So far, businesses remain optimistic about both capital spending and hiring, and consumers are upbeat about the economy and job prospects. The Conference Board's consumer confidence index in March rebounded from its February decline to the highest level in nearly four years. Households reported feeling better about both present and future conditions, and their assessment of the current state of the labor markets was positive. Although the percentage of households describing jobs as "hard to get" edged up from February's 4 1/2-year low, the proportion saying jobs were "plentiful" rose to the highest level since August, 2001.

All this leaves the Fed with a tricky balancing act. The stronger the economy, the greater the need for rates to rise to assure that inflation stays down. But housing is keenly sensitive to interest rates, so overtightening could severely damage that crucial sector and possibly the overall economy. For the rest of the year, as policymakers sift through the data for clues on what to do next, investors would do well to prepare themselves for more bumpy days ahead.

By James C. Cooper


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