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The Fed's Somewhat Schizoid Stance

By Michael Wallace Over a month after Federal Reserve policymakers introduced deflation as the predominant risk factor ahead for the U.S. economy, Alan Greenspan & Co. took out some insurance against Public Enemy No. 1 (see BW Online, 5/6/03, "The Fed Identifies a New Peril"). The Federal Open Market Committee (FOMC), the central bank's policy-setting arm, trimmed the Fed funds rate by a quarter percent on June 25 to an even 1% -- the lowest rate since July, 1958. The discount rate was also reduced by a quarter to 2%.

In a somewhat schizoid balance-of-risk statement contained in its post-meeting press release, the Fed repeated what it had said in its May 6 FOMC statement -- that upside and downside risks for sustainable growth were "roughly equal," but that minor risk of deflation was likely to "predominate for the foreseeable future." San Francisco Fed President Robert Parry was the lone dissenting voice on the committee, voting in favor of a larger half-point cut.

The overall tone for the economic outlook in the post-meeting statement was relatively optimistic, with accommodative policy and productivity providing "important ongoing" stimulus. The Fed also noted that "recent signs point to a firming in spending, markedly improved financial conditions, and labor and product markets that are stabilizing." Compared to "disappointing" readings on production and labor in the May 6 statement, this was a ringing endorsement of the economy.

BUZZWORD SHORTAGE. After that upbeat introduction, however, things got a little gloomier. The Fed sighed that "the economy, nonetheless, has yet to exhibit sustainable growth." And then Greenspan & Co. moved on to possibly the thorniest topic of all: deflation. The statement reiterated that "the probability, though minor, of an unwelcome substantial fall in inflation exceeds that of a pickup in inflation from its already low level." The FOMC believes, on balance, that "the latter concern is likely to predominate for the foreseeable future."

At a minimum, this suggests that the Fed expects accommodative policy to remain intact until economic growth is sufficiently sustainable -- and robust -- to offset the risk of deflation. Notably absent were recent Greenspan buzzwords, such as "insurance cut," "corrosive deflation," and "firebreak," though those verbal signposts in recent testimony had brought the market to an uneasy truce between those who thought the Fed would cut 25 points vs. those who expected a 50-basis-point trimming.

Ultimately, the Fed had to disappoint at least half the market, and bond bulls registered their frustration by selling on the news. The Treasury curve -- the difference in yields on shorter-dated and longer-dated instruments -- flattened bearishly, with yields at the front-end surging higher faster than those at the back. The 2-year note shot back above the old Fed funds target of 1.25% from 1.08%, while the 30-year bond broke to 4.45% from 4.30%.

DOURNESS DESCENDS. Accordingly, this led to a near-collapse in prices of Fed funds futures, a vehicle for market pros to bet on the future of interest rates. Though the Fed didn't slam the door on another policy step lower, Fed funds futures players slashed odds of an additional rate cut by this fall to 25%, from above 50% prior to the June 24-25 meeting.

The dour mood spread to the U.S. asset markets, where stocks quickly joined bonds on their voyage south as investors took profits. The broader stock indexes fell 1% after equivocating ahead of the decision. This suggested that the market may have limited patience over the Fed pursuing both a policy focused on deflation risk while at the same time conceding a smaller quarter-point easing. The dollar generally firmed in an extension of a move already in motion by buyers who had earlier bet the greenback would fall and who were now rapidly reversing their positions.

All in all, the Fed remains optimistic on U.S. economic resilience, it's still wary of deflation, and it's apparently reluctant to test the "zero bound" on policy. At stake is 50 years of inflation-fighting credibility, which the markets may find increasingly difficult to square with the Fed's current position. Wallace is a senior investment strategist for MMS International

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