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Steady, Sort Of, at the Fed

By Michael Wallace Will it be business as usual for Alan Greenspan & Co. at the Oct. 28 meeting of Federal Reserve policymakers? Probably. All indications are that the central bank will maintain its "very accommodative" 1% Fed funds rate and leave its bias unchanged.

Still, even if the post-meeting statement issued by the Federal Open Market Committee, the Fed's policy-setting arm remains mostly a dull carbon copy of the September version (see BW Online, 9/17/03, "From the Fed, Bland News Is Good News"), chances are growing that the Fed will seek to acknowledge what the financial markets appear to be taking as a given: U.S. economic growth is clearly picking up a head of steam.

Recent comments by Fed officials bear out the view that the status quo will remain intact next week -- but the remarks also highlight subtle changes that may be included in the Fed's policy stance, which splits the outlook for economic growth and price stability. Wall Street has clearly turned away from where the Fed's current official policy stands: "[On] balance, the risk of inflation becoming undesirably low remains the predominant concern for the foreseeable future."

BEHIND THE CURVE? One obvious way for the Fed to reaffirm its inflation credentials with Wall Street would be to upgrade its view of the economy's prospects from "upside and downside risks roughly equal" to risks "skewed to the upside" (see BW Online, 9/4/03, "Bond Markets: Fool Me Once..."). While such a bold stroke probably won't happen this month, it could be adopted at the Dec. 9 FOMC meeting -- especially if the government's initial estimate of third-quarter gross domestic product on Oct. 30 comes in at 6% and possibly higher, as many economists expect. Another positive figure for nonfarm payrolls in the Nov. 7 employment report could also sway the Fed to change its risk assessment.

That doesn't mean the Fed can't retain its focus on the potential for deflation to develop at upcoming policy meetings, which would provide it with the rhetorical cover to maintain an accommodative policy stance into 2004.

Fact is, financial markets are betting that the Fed is starting to fall behind the curve on growth, if not inflation. This may not be a particular concern for the central bankers, who reiterated that "policy accommodation can be maintained for a considerable period" in their September statement. Still, according to odds implied by Fed funds futures, a vehicle for betting on the future direction of rates, the market sees about a 60% chance that the Fed will hike rates by a quarter-point by Mar. 31.

MOVING POSITIONS. That's lower than the 100% chance that futures implied in the immediate wake of the positive September payrolls figure, released Oct. 7. But as long as economic data continue to surprise on the upside, the futures market will signal that it expects some policy slack to be taken off the table next year.

It's notable that policy "doves" (i.e., those who consider fostering economic growth an equal policy priority to battling inflation), such as San Francisco Fed President Robert Parry and Fed Governor Ben Bernanke, appear to have shifted their dogmatic stance that the Fed should remain ultra-accommodative. In mid-October, Parry noted that his view had changed since his June dissent from the rest of FOMC voting members, who favored a quarter-point easing.

Back then, Parry had favored a more aggressive half-point cut. Now he says he's more convinced about an economic recovery than he was even a month ago. He even suggested that prolonged accommodation did not necessarily imply the Fed would keep rates flat, though he says he sees little risk of inflation creeping up.

Likewise, Bernanke, widely considered the Fed's deflation expert, has proclaimed that "price stability had been achieved," and that the economy is moving toward a "sustainable recovery with low inflation." Bernanke did not sound as concerned about battling deflation as he did earlier this year (see BW Online, 5/30/03, "A Deflation Guru's Prescription for Japan").

JOB WATCH. In a strange role-reversal, Fed "hawks" (whose policy focus is more on maintaining price stability than on fostering economic growth) have expressed some lingering concern about deflation risks. Richmond Fed President Alfred Broaddus remains anxious about slack in the economy and the labor market, mindful that disinflation probably still remains a danger. He also considers the dark side of sizable productivity gains -- their potential to tip inflation lower and impede an improvement in unemployment figures.

Even Bernanke admits that the economy would likely have to create in excess of 150,000 jobs per month for several months to convincingly take up slack in the labor market, which argues for patience on policy. Yet St. Louis Fed President William Poole has warned that productivity gains could slow once hiring begins in earnest, which would require "Fed vigilance" on the inflation front.

With stronger economic growth on the horizon but concerns still lingering about "an unwelcome fall in the rate of inflation," it looks like FOMC members may gravitate more toward the center of the dove-hawk spectrum. And that could create a consensus among policymakers that sets the stage for a shift in the Fed's stance -- away from accommodation and toward a possible preference for tighter money -- some time next year. Until then, an official no-change-in-policy from the central bank is most likely. Wallace is a senior market strategist for MMS International based in Belmont, Calif.

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