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Will Greenspan Shift Gears?

By Michael Wallace Quite a lot has happened since Federal Reserve policymakers last met on Oct. 28. A string of strong data reports has shown that U.S. economic fundamentals have solidified. And the stock market has once more moved toward recovery highs. Sure, trade tensions with key partners Europe and China have worsened. Plus, the dollar has weakened, and bond-market yields have crept back up toward their highest levels since fall.

Still, you would think most of the economic reports of late have given the Fed's hawks, who consider controlling inflation the top priority, plenty of ammunition to convince their fellow policymakers that the central bank needs to shift its policy bias away from the risk of falling prices toward a neutral stance sooner than later.

Of course, the opposing doves, who believe fostering growth is the key consideration, have also had good news. With the November employment report due out on Dec. 5 likely to show a sizable gain in nonfarm payrolls, the Fed will be hard-pressed not to rebalance its policy stance in some fashion at its Dec. 9 meeting.

SIGNS OF STRENGTH. Alan Greenspan & Co. would be well served by acknowledging mounting evidence that sustainable growth risks have shifted to the upside. To provide cover for a continuation of its accommodative policy into 2004, the Fed could repeat its mantra that the risk of an unwelcome fall in inflation exceeds that of a rise in the low level of inflation. But that should not preclude it from eliminating its current "predominant" bias toward disinflation risks.

Signs of gathering economic strength are undeniable. Third-quarter gross domestic product was revised up to 8.2% on Nov. 25 -- the highest figure in over two decades -- and subsequent real economic and sentiment gauges have both been pointing to another strong showing for the fourth quarter. Supported by reports of a solid start to the holiday shopping season and fresh signs of job growth, fourth-quarter GDP is expected to top 6%, with a strong possibility of an upside surprise.

That would result in an average growth rate of over 7% for the second half of 2003, with a number of omens auguring that momentum will spill over into 2004. Predictions of a "flash in the pan" jobless economic recovery are starting to sound hollow.

FIRMER TONE. And the November payrolls report may stretch those naysaying arguments to the breaking point. Despite the Bureau of Labor Statistics' confirmation that the California grocery-worker strike will subtract a net 63,000 from November payrolls, our forecast remains for a headline gain of 170,000 jobs.

This compares to a more conservative 147,000 median gain from our survey of economists, but it would nonetheless extend the winning streak on payrolls to four consecutive months, based on subsequent upward revisions. Results in line with either forecast would reveal a much stronger-than-expected underlying trajectory in job growth than previously assumed.

Moreover, we at MMS expect a payroll gain of 225,000 in December, followed by a 200,000 increase in January, though the unemployment rate should linger at 6%. This firmer tone in the labor market has been corroborated by other indicators, such as the sharp drop in the four-week moving average for jobless claims to 358,000 and the Institute for Supply Management employment index moving above the 50 boom/bust line for the first time in over three years.

Financial markets are reflecting the mounting evidence that job growth and economic strength are gathering momentum. The major stock indexes are finishing the year in fine shape, with 20% to 50% gains and a strong seasonal tailwind. Treasury yields are flashing warning signals again, with the yield on the 2-year note back above 2%, and the 5- and 10-year notes nearing 3.5% and 4.5%, respectively. The yield curve, the spread between 2-year notes and the 30-year bond, is the flattest it has been in six months, barely staying above three percentage points.

VIRTUE OF PATIENCE. Mostly, this highlights to the increasing possibility that the Fed may be ready to consider dropping from its post-meeting statement lexicon the phrase "considerable period." In fact, whether the shift to a neutral policy from a more accommodating one is a smooth or rough adjustment may depend on how long Greenspan sticks with the "considerable period" policy window. He could and likely should opt to shift to a more finite view espousing "policy patience."

Indeed, it might be more prudent for Greenspan to dispatch his current wording early, rather than be forced to do it by the markets later. The phrase appears to have already lost currency within the Fed and could cost the central bank credibility down the road.

In the end, it's all in the timing. Greenspan has generally made some astute calls on when to make policy shifts in the past. The markets will be watching carefully to see how the chairman manages to navigate some pretty tricky policy currents this time around. Wallace is a senior market strategist for MMS International

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