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A Big Jolt from the Fed's Small Switch

By Michael Wallace Well, at least one part of the Federal Reserve's policy statement went according to plan. As was widely expected, the Federal Reserve Open Market Committee (FOMC) maintained the Fed funds target rate at a near-half-century low of 1% on Jan. 28 to cap its first policy meeting of election year 2004.

But the committee's post-meeting statement contained a surprise for the markets. In the wake of an internal debate on the efficacy of verbal guidance about policy to the markets, it decided to jettison the phrase that "policy accommodation can be maintained for a considerable period." Instead, the Fed promised that it would "be patient" before changing course.

That watered-down version of leaving rates unchanged indicated to the markets that the Fed's underlying convictions have shifted closer toward tightening monetary policy. The key phrase now reads: "With inflation quite low and resource use slack, the Committee believes that it can be patient in removing its policy accommodation."

HIRING DOUBTS. Though the overall policy bias remained "roughly equal" (between sustainable economic growth and inflation risks), the Fed's unexpected rhetorical shift fanned a wave of selling on Wall Street. The financial markets had been convinced that Greenspan & Co. would hold fast to the "considerable period" verbiage on policy accommodation. While most other aspects of the policy statement were not significantly altered from the previous edition of December 9, 2003, the surprise change persuaded investors to push the benchmark Dow Jones industrial average down more than 140 points, after meandering some 35 points higher ahead of the statement's release at 2:15 p.m. ET.

The wording change may seem like a small thing, but in the financial world, it was a shock. Previously, the Fed was secure in "maintaining" an easing policy bias, while after this meeting, it said it would be patient before "removing" the current bias. The "considerable period" phrase had lasted exactly 5 months and 16 days from the last major shift in wording about Fed policy. It may have felt like a verbal somersault, but it was meant to gently guide the rebounding markets back to earth as the economic pulse quickens.

Of course, while the Fed is still banking on productivity and economic growth, it did appear to vacillate on the subject of employment. Back in December, it characterized the labor market as "improving modestly," but after the paltry 1,000 gain in December nonfarm payrolls, the central bank now concedes that new hiring "remains subdued." It pinned its hopes for future job growth instead on other labor indicators, such as declining jobless claims and anecdotal survey data.

"CAUGHT OFFSIDE." Reaction in the bond market was just as swift and violent as in stocks. Ultralow Treasury yields, which had been subdued by the Fed's previous stance, shot up almost a quarter percentage point before subsiding somewhat ahead of the close. The surge was most pronounced at the shorter end of the maturity spectrum, where rates had fallen to almost 1.5% in recent weeks before vaulting back above 1.8% after the FOMC statement. The yield on the 10-year note moved up to 4.25% after hovering just above 4% in recent weeks.

It could have been worse. As Glenn Compton, vice-president at Citigroup Global Markets explains: "The [bond] market was caught offside, but the Fed picked a good time for the verbal shift with yields already so low." Indeed, recent surveys of institutional funds suggested that dealers had already begun to position more defensively ahead of the Treasury's quarterly refunding and January payrolls data due in the first week of February.

The major stock indexes each tumbled more than 1.3% as investors fretted that the Fed may not be so accommodating in coming months. However, the dollar rebounded smartly after an apparent round of intervention by the Bank of Japan earlier in the session and with the prospect that U.S. yields could be headed higher sooner than expected.

TIGHTENING ODDS. Meanwhile, Fed fund futures, a vehicle for market pros to bet on interest rate moves, are now implying 100% odds of a quarter-point tightening by the Aug. 10 FOMC meeting, vs. odds of roughly 60% before Jan. 28's statement. As such, bets are already being placed that the Fed will replace accommodation with a more proactive stance ahead of November's elections.

One other interesting thing to note: Some fresh faces were among the voting regional Fed presidents for 2004 who took part in the proceedings. Thomas Hoenig and William Poole, who have a track record of being more hawkish on policy (i.e., giving greater weight to fighting inflation than fostering growth), replaced, among others, the more moderate Robert Parry and Jack Guynn. While this cast change may not have played a huge role in the Fed's more hawkish language, it could be a factor in coming months that speeds change in that direction. Wallace is an independent economic consultant based in San Francisco

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