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Why the Fed Is Content to Fly Low

By Michael Wallace After the Federal Reserve's surprising 50-basis-point "insurance" cut in interest rates on Nov. 6, few expected a coda at its Dec. 10 policy meeting -- not even a change in its policy bias. And sure enough, the Fed didn't disappoint, standing pat on rates and leaving its neutral policy outlook intact. Indeed, the central bank appears content to fly beneath the markets' radar screen through yearend. Better that Wall Street's focus should fall on the Bush Administration's efforts to repair fiscal policy and business confidence with the appointment of a new Treasury Secretary and SEC chairman.

The language of the Federal Open Market Committee's post-meeting statement indicated a balanced assessment of growth and inflation. The FOMC statement declared: "The limited number of economic indicators since the November meeting, taken together, are not inconsistent with the economy working its way through its current soft spot."

However, the odd use of the double negative hardly suggested a ringing endorsement of economic recovery. The Fed also cited its belief that its accommodative policy -- with rates continuing near four-decade lows -- and robust productivity gains provided important ongoing support to the economy.

BARELY A MURMUR. A quick read through the statement might mistakenly leave the impression that the Fed is preparing to take back some of its past cuts. But the intentionally opaque sentence construction -- classic "Greenspeak" -- suggests that the Fed will remain on hold for a not indeterminate amount of time. Translation: Rate hikes are likely not in the offing.

Market reaction to the latest FOMC pronouncement was on par with the underwhelming statement. Stocks held on to their morning gains, Treasuries dipped then recovered, and the dollar scarcely acknowledged the Dec. 10 event. Overall, since the jumbo rate cut on Nov. 6, investors haven't had much reaction to the Fed's moves.

Just after that move, the stock market rose to two-month highs before giving back a good chunk of its gains last week. Yields on 2-year Treasury notes are only fractionally higher than before the Nov. 6 cut, while the yield on the 30-year bond is back below 5% after racing to as high as 5.15%. The yield spread between 2-year notes and the 30-year bond flattened sharply initially, to +290 basis points as the Fed was seen as finished cutting rates for the current cycle, before returning to +310 basis points.

QUALIFIED TONE. The Fed appears to have taken some comfort in the markets' reaction, sticking with its "accommodative" stance. And the markets in turn are at least giving the Fed some credit for an appropriate approach.

On the economic front, the lagging indicator of unemployment is starting to track previous episodes of economic squishiness. It jumped to 6% in November, matching the highest rate posted since August, 1994. This result aptly revealed the "soft spot" the Fed had warned about in its November statement, though sentiment indicators have recovered somewhat, aided by the recovery in the stock market and diplomatic efforts between Iraq and the U.N. to stave off war. This may account for the Fed's qualified tone in the Dec. 10 statement, which lacked the urgency that accompanied the last rate cut.

Since the Fed's November reduction, the European Central Bank has joined the party with a half-point easing of its own, though British policymakers have held their fire, and the Bank of Japan continues to sit tight until the full force of banking reforms becomes apparent.

WHAT'S NEXT? In the meantime, President Bush has cleaned house on his economic team, signaling a fresh resolve to legislate new stimulus measures even as the economy coils for recovery. A package of tax cuts that the President envisages, however, is the sort of stimulus that Fed Chairman Greenspan will likely find palatable. Thus, while inflation risks remain subdued, we at MMS International believe the Fed is likely to keep policy accommodative to repair investor trust.

What does the market think? Fed funds futures, a trading vehicle for market pros to bet on the future direction of interest rates, remain divided on whether the first move of 2003 will be another ease or the first of a string of hikes. The FOMC said little on Dec. 10 to cure the market of this ambiguity. Michael Wallace is a senior market strategist for MMS International

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