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A Sluggish Recovery Slows the Fed

By Michael Wallace Patience appears to be a virtue for Alan Greenspan & Co. The Federal Reserve's rate-setting arm, the Federal Open Market Committee (FOMC), steadfastly maintained its current accommodative stance on monetary policy at its Mar. 16 meeting -- as almost everyone had expected.

Judging from its accompanying policy statement, the FOMC seemed a bit more impatient with the economy's progress, especially with regard to the labor sector. The Federal funds base rate stayed anchored at 1%, while the forward-looking policy bias remained balanced with respect to sustainable growth and inflation risks.

EVER-SO-SLIGHT DOWNGRADE. Fed watchers had little doubt heading into the March meeting that the central bank would largely choose discretion over valor in its pronouncements. Given the string of disappointing U.S. jobs reports thus far in 2004 and the dent it has put in investors' equity portfolios -- and professional fund managers' sentiment -- the Fed's restraint is hardly a surprise.

Other factors may have played a part in its continued circumspection. The geopolitical landscape has been marred by the Mar. 11 terror strike in Spain, which helped topple the incumbent government -- potentially heightening election-year uncertainty in the U.S., given the close Presidential contest.

If such external factors figured in the FOMC's policy debate, however, we won't know until the meeting's minutes are revealed in a little over a month. Only subtle clues could be gleaned from the latest statement, which offered few changes from the Jan. 28 version. Among these, the Fed appeared to ever so slightly downgrade its view of the economy. Whereas the January statement cited evidence that "confirmed output is expanding briskly," the Fed concluded this time that output was merely "continuing to expand at a solid pace."

MUTED PRICES. Indeed, the central bank acknowledged in January that while new hiring "remained subdued," it was eyeing indicators that suggested improvement in the labor markets. In the latest version, the best it could muster was that "although job losses have slowed, new hiring has lagged."

At least on the inflation front, increases in core consumer prices were "muted and expected to remain low," though even this drew some ire from market watchers. The producer price report hasn't been published yet in 2004, thanks to government revisions, and oil prices have been relentlessly escalating.

Market reaction initially favored bonds over stocks, as scrutiny of the Fed's policy patience gave way to focus on its slightly more downbeat assessment of the economy. Stocks later regained their footing. Treasury yields dipped, led lower by intermediate-maturity issues.

SMALLER ODDS. Yet, market players don't appear to think bond yields will head much lower. With the 2-year note easing back below 1.5% and the 10-year note testing the waters again below 3.7%, bond dealers contacted by Action Economics retained some healthy skepticism about another decisive break lower. That doubt was fanned by a Japanese press story overnight that the Bank of Japan could scale back its brisk purchases of U.S. Treasury issues if Japan's economy continues to recover. The BoJ has bought Treasuries as part of its intervention efforts to forestall the U.S. dollar's slide vs. the yen.

Prior to the release of the FOMC's Mar. 16 statement, the outlook implied by Fed funds futures (a vehicle for traders to bet on interest rate changes) was roughly a 50-50 possibility that the Fed would hike rates by a quarter-percent early this fall, prior to the November elections. That margin of confidence was sliced in half following the Fed's subtly more dour statement, showing only about a 25% chance of an increase by then.

At this pace, any more frustration with the economy may force the Fed to maintain its accommodative stance into 2005. San Francisco-based Wallace is global market strategist for Action Economics

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