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Buying Time at the Fed

By Michael Wallace Like Lynryd Skynryd devotees clamoring for yet another rendition of Free Bird, the markets were looking for the Federal Open Market Committee to play the same tune it has over the past few meetings -- and they weren't disappointed. At an Oct. 28 policymaking meeting, Alan Greenspan & Co. opted to keep the benchmark Federal funds rate anchored at 1% and maintained that policy accommodation could remain in place for a "considerable period."

The move also reassured investors that there would be no rhetorical U-turn, signaling a possible change in the Fed's "accommodative" stance -- at least until the FOMC's next meeting, on Dec. 9. Whether such optimism is sustained through the interim will depend in large part on some important economic reports in the pipeline. The policy statement issued at the conclusion of the meeting demonstrated Greenspan's complete mastery of strategic minimalism, aimed at avoiding undue market disturbance.

Indeed, the text retained all of the buzzwords from the September statement while only cautiously tweaking the outlook on unemployment. In terms of economic growth, "the upside and downside risk to the attainment of sustainable growth for the next few quarters are roughly equal." In contrast, disinflationary risks -- the potential for "an unwelcome fall in the rate of inflation"-- remained "the predominant concern for the foreseeable future."

NARROWING GAP. Though the Fed acknowledged that "the labor market appears to be stabilizing" instead of "weakening," as was the case in September, this apparently wasn't sufficient to tip the scales toward higher-growth risks. Given the fact that business pricing power and the core consumer price index "remain muted," this provided the cover to await more economic proof. The Fed evidently wants to see that the pickup in growth is translating not only into sustainable jobs growth, but into the risk of a climb in inflation. Meanwhile, policy will remain accommodative at least into 2004 (see BW Online, 10/29/03, "The Fed Sticks to Its Story").

The FOMC's opionion had no dissenting votes. In fact, the lone voice in favor of a deeper cut this summer -- San Francisco Fed President Robert Parry -- recently renounced his pessimism on growth and said he was more convinced of an economic recovery today than in September. Even Ben Bernanke -- the deflation guru -- has appeared more upbeat of late. This indicates that the gap between the policy hawks and doves is closing. And that may lay the foundation for a change in the Fed's stance toward a tightening bias by early 2004.

The markets warmly received the FOMC's words. Treasuries enjoyed a sharp relief rally in the wake of the as-expected FOMC statement, and the bounce in debt securities of every maturity lifted prices that had dropped earlier in the session. The yield curve grew steeper, with the spread between the 2-year note and 30-year bond widening 10 basis points, to 342 basis points. Stocks also managed to build on earlier gains, closing solidly higher. The dollar pulled back vs. other major currencies on the perception that a near-term rate hike isn't in the cards.

SIZZLING GROWTH? Fed funds futures, a trading vehicle for market pros to bet on future moves in interest rates, had been implying about a 75% chance of a quarter-point hike by the end of the next year's first quarter. But after the statement was released, the futures market slashed those odds back down to around 50%. The Fed's ongoing infatuation with monetary laxity should ensure that odds of a first-quarter hike next year remain subdued in the near term. This will be increasingly difficult to square against stronger gross domestic product growth in the second half of 2003 and an improving labor market.

Indeed, MMS expects that GDP will sizzle along at a 5% to 7% rate in the third and fourth quarters of 2003. In 2004, the Fed should shift to a tightening bias by the first quarter, with a start in the tightening cycle around midyear.

The Fed may still have some time before policy accommodation for a "considerable period" becomes a "finite horizon." But forthcoming data could stretch the central bank's credibility, should it wait too long. No matter how artfully the chairman crafts the Fed's communiques, economic fundamentals -- and ultimately, the market -- will always have the last word. Wallace is a senior market strategist for MMS International.

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