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Greenspan's Parting Moves

By Michael Wallace In the third-to-last Federal Reserve policy meeting of the Greenspan era, the central bank did just what everyone expected on Nov. 1, hiking the benchmark Fed funds rate another quarter point to 4%. This marked the 12th consecutive rate hike in the current policy cycle -- from near historic low levels of 1%. This move, along with renewed unanimity among members of the Federal Open Market Committee, the Fed's policy-setting arm, and the language of the post-meeting statement, strongly suggests that the central bank will continue to take away past policy accommodation by raising rates into 2006.

The statement was largely as expected, with customary refinements rather than any wholesale changes. The Fed noted elevated energy prices and hurricane disruptions "temporarily depressed output and employment." It also said that while the "cumulative rise in energy costs have the potential to add to inflation pressures...core inflation has been relatively low in recent months and longer term inflation expectations remain contained," similar to the wording of its September communiqué (see BW Online, 11/2/05, "Good News on Prices? Listen Up").

The FOMC did appear to subtly upgrade its economic assessment, however, noting that economic activity would "likely be augmented by planned rebuilding in the hurricane-affected areas." Note, as well, that the decision was unanimous, as Governor Mark Olson effectively recanted his dissent from the Sept. 20 meeting. The persistence of hawkish rhetoric on inflation risks in the aftermath of recent storms, given dislocations in the U.S. energy infrastructure, provided the blueprint for similar language in the statement, though inflation expectations remained in check.

OIL RELIEF. The Nov. 1 meeting took place as crude oil futures retreated back below $60 per barrel -- in sharp contrast to the $71 per barrel level seen in the weeks leading up to the September meeting. The declines in crude and gasoline prices appear to have given the Fed confidence that energy sticker shock is abating.

Unseasonably warm weather in the Northeast and vows from OPEC to tap spare production capacity have cooled demand for scarce refined products, such as heating oil and natural gas. Of course, the Fed did retain the right to "respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability."

The Fed maintained its boilerplate language that "upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal" and that "accommodation can be removed at a pace that is likely to be measured." This virtually confirms that the final policy steps of Greenspan's term will be gradual, but persistent, hikes -- certainly through yearend, if not through the expected leadership handover.

FLEETING BOND RALLY. If confirmed, Ben Bernanke, the chairman-designate, will take the helm beginning Feb. 1, 2006, with his first policy meeting set for Mar. 28. That would likely put the Fed funds level at 4.5% for the handover and give Bernanke the opportunity to either pause or tighten, with one more move potentially taken to establish continuity -- and his own inflation-fighting credentials.

With core (excluding food and energy) prices for the key personal consumption expenditure (PCE) inflation gauge steady at 2% year-over-year, the real (i.e., adjusted for inflation) Fed funds rate stands at precisely 2%. This gives policymakers a little breathing room, given that it is now nearer to its long-run average in the 2% to 3% range.

After the policy tightening and statement came in pretty much as Wall Street had expected, the bond market enjoyed a very fleeting relief rally on Nov. 1. Yields on the benchmark 10-year note dipped toward session lows of 4.53%, before snapping back toward 4.6%.

VINDICATED FED. The yield curve extended its flattening bias, as front-end yields remained elevated on the confirmation of the Fed's stubborn tightening path, paired with the relative calm about core inflation and inflation expectations. The dollar traded fairly flat vs. other major currencies after giving up earlier gains, while stocks remained depressed in the wake of Dell's (DELL) less-than-stellar earnings report.

Fed funds futures, a trading vehicle for market pros to bet on the future direction of interest rates, settled marginally lower in the wake of the Fed hike and a statement offering no indication of a pause near-term. The market remains fully priced for a 4.25% rate at yearend and is almost 90% of the way toward pricing in another measured hike to 4.5% as Greenspan's ultimate gesture -- exiting the way he began, in tightening mode.

Still somewhat uncertain, though, is what Bernanke will do at his first meeting on Mar. 28. Currently, implied Fed funds are showing about a 50-50 risk that he will demonstrate the Fed's traditional commitment to price stability with a rate hike.

The Fed has been vindicated in keeping the tightening cycle on track by the resilient U.S. economic performance in the wake of the hurricanes back in September. Greenspan appears to remain determined to round out his illustrious career by handing over the bridge of the policy ship in good working order, with inflation well-contained. That will leave Bernanke potentially with some fine-tuning to do early in his regime, but with a confident and firm grip on inflation heading into next year. Wallace is global investing strategist for Action Economics

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