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A Dovish Sway in the Fed's Stance

By Michael Wallace Leading up to their June 25-26 policy meeting, Federal Reserve officials had been noticeably reticent about the accounting crisis spreading fear on Wall Street. Alan Greenspan & Co. continued in that vein on June 26. Fed officials have often said they don't target stocks -- or any other asset class -- and true to form, the Federal Open Market Committee's statement at the close of the meeting stuck solely to Job One: policy.

While the Fed kept the benchmark Federal funds rate target at 1.75% and retained its neutral policy bias -- which sees risks evenly balanced between inflation and slow economic growth -- it did take a slightly more dovish tack on the economy. (Policy "doves" believe that fostering economic growth takes priority over controlling inflation.) Though the Fed stood scrupulously clear of developments in the financial sector, it did acknowledge that "both the upward impetus from the swing in inventory investment and the growth in final demand appear to have moderated."

This statement vindicated market observers who had been expecting policymakers to take a more dovish slant. The FOMC still expects the rate of increase in final economic demand to pick up over the coming quarters, buttressed by strong productivity growth.

UNANIMOUS VOTE. Most important, the Fed said "the degree of the [economic] strengthening remains uncertain," though it did stop short of dropping any hints about stepping back from the neutral policy bias while most recent real economic indicators continue to point toward a consolidation of the recovery. The roll call of the vote by committee members to leave policy unchanged was unanimous.

Prior to the 2:15 p.m. EDT announcement, stocks broke below their post-September 11 lows as worries grew about the June 25 WorldCom accounting debacle. Corporate accounting and governance concerns, along with terrorism fears and weak earnings, appear to have counteracted the Fed's post-September 11 emergency liquidity measures.

Not only have equities come full circle since last fall but yields on U.S. Treasury issues are also swiftly approaching lows again from this slow-burning, home-grown crisis of confidence. After peaking in March near 3.73%, the yield on the 2-year note has moved over a percentage point lower, touching 2.55% following the news of the WorldCom accounting debacle on June 25. That's just a quarter point away from lows of 2.26% on Nov. 7 last year.

WIDENING SPREAD. But yields on longer-dated Treasury issues tell a different story. The burgeoning fiscal deficit and accommodative Fed monetary policy have hindered the long end of the yield curve, which has underperformed the short end, despite the lack of inflation. The yield on the 10-year note neared 4.6%, well down from March highs of 5.47%, but still some distance from Nov. 1 lows of 4.09%. The yield spread between the 2-year note and 30-year bond pushed out to nearly 275 basis points, almost matching the widest level seen in the wake of the September 11 attacks.

Market reaction to the FOMC's stand-pat position on rates was blunted by the volatile action in equities prior to the announcement, though stocks, widely deemed oversold by technical analysts, pared their worst losses to close nearly unchanged. This caused Treasuries to give back over half of their near 2-point gain. The Fed certainly threw no bone to stocks in its policy announcement, but by the same token Treasuries weren't bolstered much either. The trade-weighted dollar index bounced from 2-year lows of 105.90 to 107 before running out of gas.

Fed funds futures, a vehicle for market pros to bet on future moves in interest rates, rallied along with shorter-dated Treasury issues, though they were left in limbo following the FOMC decision. Expectations for any interest rate hikes have all but been removed from the immediate horizon. The implied rates from Fed funds futures all shifted below the Fed funds target rate of 1.75% through October. November still shows some slight risk of a hike, but not until December do futures prices put the odds at over 50%. S&P MMS doesn't expect the Fed to hike rates until January, 2003.

FORCE OF GRAVITY. While the central bank appeared not to acknowledge the angst on Wall Street and the sharp deterioration in investor confidence, it surely must have discussed these issues behind the scenes. The gravitational pull of lower stock prices and declining Treasury yields somewhat offset one another -- and this apparently supported the Fed's decision to focus on primarily on real indicators.

And yet, the Fed's use of the words "moderated" and "uncertainty" speak volumes. It looks like Greenspan is prepared to keep monetary policy accommodative until final consumer and business demand clearly strengthens -- to the point that the central bank can no longer ignore risking a return of inflation. Wallace is a senior market strategist for Standard & Poor's/MMS International

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