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The Fed Identifies a New Peril

By Michael Wallace No big surprise: The Federal Reserve's policy-setting arm, the Open Market Committee (FOMC), held the Fed funds rate steady at 1.25% at its May 6 meeting. But the central bank pulled off a clever rhetorical feat in the statement announcing its decision with a subtle shift in its view of the "balance of risks" regarding its twin, long-run goals: price stability and sustainable economic growth. By reweighting that balance, the central bankers showed they have an eye on a new concern, the possibility of deflation.

Against these two goals, the "balance of risk was weighted toward weakness over the foreseeable future," according to the press release. Yet, within the balance-of-risk statement, the Fed tilted the relative scales of price stability and growth to emphasize the former over the latter. After punting on assessing the risks at its March meeting (see BW Online, 03/19/03, "The Fed Waits for the Fog to Lift"), most likely because of the impending war in Iraq, the Fed wasn't looking for cover this time.

In essence, it chose to emphasize the "minor" risk of deflation over that of sustainable economic growth, which it characterized as balanced. Together, the overall balance of risk was "weighted toward weakness over the foreseeable future."

BETWEEN THE LINES. To use the Fed's own words from the statement's key third paragraph, "the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal." By way of contrast, "over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level."

Greenspan & Co.'s rhetorical gymnastics suggest that the "unanimous" policy agreement came following some dissent and heavy debate. In a sense, the Fed appears to have become a victim of its own success in vanquishing inflation.

Reaction to the Fed raising a new "unwelcome substantial fall in inflation" option on the risk assessment was sharp and intriguing. Bond futures gained nearly a point, and the Treasury yield curve -- the spread between the 2-year note and 30-year bond -- rapidly widened by 7 basis points, to +332 basis points. Two-year yields tumbled from 1.57% to 1.42%, while the 30-year yield declined 10 basis points to 4.75%. Stocks managed to stay in positive territory, however, optimistically reading a rate cut between the lines. The dollar was the weak link -- the trade-weighted dollar index fell more than 1%, to four-year lows.

Those looking for a rate cut in advance of the June 24-25 FOMC meeting may be in for a disappointment. The Fed also dropped the "heightened surveillance" language introduced in its March statement, which was the presumed code phrase for a potential intermeeting move. Now, it just warns of the risk of "weakness." Indeed, the Fed could not, with a straight face, cast risks as "economic weakness," given its comments regarding balanced economic risks, vs. inflation risks.

DEPLETED ARSENAL. Presumably, even if the Fed is only slightly concerned about deflation, this would justify elevated vigilance, given balanced economic risk. Apparently, the central bank did not wish to signal that it might act outside its scheduled meetings, though the markets could assume otherwise.

In late April, Chairman Greenspan updated his semiannual monetary policy report before Congress. In that testimony, he failed to endorse a recovery in business spending, and he remained nervous about elevated jobless claims. The latest policy statement also expressed disappointment over weak production and employment. Clearly, the Fed remains concerned about the business sector and labor trends, which have obscured the benefits from the postwar drop in oil prices, improvement in consumer confidence, and firming financial markets.

In a roundabout way, the Fed has maximized its policy options. Through their cryptic reading on the economy and deflation, the central bankers are seeking to retain as much flexibility as possible. And with just 125 basis points left in the Fed's rate-cutting arsenal, that could even extend to some unorthodox policy moves in the future. Wallace is a senior investment strategist for MMS International

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