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Rebels with a Cause at the Fed

By Michael Wallace It was pretty much a foregone conclusion. Alan Greenspan & Co. kept a steady hand on the interest rate switch at the Sept. 24 meeting of the Federal Open Market Committee, the Federal Reserve's policymaking arm. As was widely expected, the FOMC left the target federal funds rate unchanged at 1.75% and maintained its policy bias toward defending against weaker economic growth.

But the Fed's communique released after the close of the meeting contained a couple of real surprises. And based on those developments, it looks as if the central bank left the door open for a rate cut in the near future -- perhaps even ahead of its next scheduled meeting on Nov. 6.

The most significant development was the vote against Greenspan's current policy stance by two FOMC members: Fed Governor Edward Gramlich and Dallas Fed President Robert McTeer. According to the post-meeting statement, both "preferred a reduction in the target for the federal funds rates." On the scale of policy "hawks" (those who think containing inflation is the highest priority for monetary policy) and "doves" (whose primary policy aim is to foster economic growth), McTeer is widely seen as a dove, so his vote is not a complete surprise. But Gramlich is generally viewed as a moderate in such matters.

WAR PROSPECTS. Moreover, both voted for a steady stance at the FOMC's previous rate-setting meeting on Aug. 13. Obviously, developments since that date have pushed them off the fence. It may be only a matter of time before other FOMC voters join their camp.

And some subtle shifts in the Fed statement provided further policy clues. In August, the Fed blamed "problems in corporate reporting and governance" for subpar economic growth. But this time around, it warned of "heightened geopolitical risks." While the Fed doesn't typically speculate over war prospects, it seems to be anticipating the next pretext for a potential rate cut, should market sentiment or credit conditions take another turn for the worse. This may reflect the risks cited by the dovish dissenters.

Indeed, Greenspan has a track record of aggressively accommodating perceived financial, systemic, or event risks. Take a look at the Fed's aggressive easing in the wake of crises such as the Long Term Capital Management hedge-fund meltdown, the Russian debt default, and the September 11 terrorist attacks.

CLEARED HURDLES. Otherwise, the majority of the FOMC members remained hopeful that "the current accommodative stance of monetary policy, coupled with still robust underlying growth in productivity, should be sufficient to foster an improving business climate." In addition, the committee suggested that "aggregate demand is growing at a moderate pace."

Since the last meeting, two big August data hurdles for the economy have been cleared, with the unemployment rate falling to 5.7% and retail sales rising 1%. These improvements occurred alongside only modest housing-sector declines from extremely high levels. Even the latest consumer confidence data for September, released on Sept. 24, proved more resilient than expected, when taking into account upward revisions for August.

But some powerful negative factors remain in place. The Nasdaq index registered its lowest level in six years on Sept. 24, and business confidence clearly remains at a low ebb. To top it off, oil prices have surged since the Aug. 13 FOMC meeting to well above the $30-per-barrel threshold, based on the increasing risk of an armed conflict with Iraq -- a potential "tax" on business profits and consumer spending.

FUTURES BETS. It's the uncertainty about the stock market and the effects of a possible rematch with Saddam Hussein that has sent investors scurrying into the relative safety of Treasuries. As a result, yields on two-year Treasury notes fell an additional 15 basis points, to 1.85%, since the Fed's August meeting as investors seek the relative safety of bonds. The 30-year Treasury yield sank nearly 40 basis points since August.

And judging by the Treasury market action on Sept. 24, a sizable number of market players are betting that the Fed will tweak rates lower. In trading that day, yields on Treasury issues reached the lowest levels seen in four decades before backing up modestly. Additionally, Fed funds futures, a trading vehicle for market pros to bet on future interest rate moves, priced in about an 18% chance of an inter-meeting move in October, before the FOMC debates again on Nov. 6.

The calendar may also be partly responsible for some of the speculation about an inter-meeting move, given congressional elections on Tuesday, Nov. 5. Surely that was the reason the FOMC meeting that week was scheduled for Wednesday the 6th. As a veteran of both sides of the political divide in Washington, Greenspan would be keen to underscore the Fed's apolitical credentials by avoiding policy moves just before election time. This would appear to raise the possibility of an inter-meeting move, if conditions warranted.

While the markets will continue to press the Fed's hand to ease, we at MMS International believe that underlying real economic strength will keep Greenspan & Co. on hold through yearend. Wallace is a senior market economist for MMS International

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