By Michael Wallace
For days, the financial markets had been gearing up to hear the worst on June 15: a higher-than-expected reading on the consumer price index (CPI) for May -- and hawkish Senate testimony from Federal Reserve Chairman Alan Greenspan. When both events turned out to be less onerous than expected, investors heaved a huge sigh of relief.
As the last major inflation benchmark before the June 29-30 Fed policy meeting, this CPI clearly carried more weight than usual. The market is still waiting on the release of the May producer price index (PPI), which has been delayed thanks to the antiquated computer systems at the Bureau of Labor Statistics.
The headline CPI result for May was a sizable 0.6% increase. But the core index (stripped of food and energy) rose only 0.2%, much as expected. True, the headline number was fattened by an 8% gain in gasoline and 0.9% jump in food and drinks, but on a year-over-year basis, core inflation rose at a 1.7% annual rate, vs. an 1.8% annual rate in April -- well below the 2% threshold that the Fed deems the level at which inflation would be seen as rising too fast. That moderate core figure helped push Treasury prices higher in active trading, sending yields sharply lower.
Still, that was only part of the story on June 15. In his renomination hearing to another four-year term, the Fed chairman's prepared testimony before the Senate Banking Committee mostly concentrated on the central bank's artful role in navigating treacherous financial seas. Greenspan indicated that recent turbulence necessitated the flexible application of a "risk-management" approach to policy, rather than a dose of inflation-targeting or some other, more rigid model (see BW Online, 6/16/04, "Inflation Isn't Dead Yet").
His post-testimony question-and-answer session with panel members was revealing. Greenspan suggested that the pace of Fed tightening is likely to continue to be "measured" -- particularly at the upcoming June 30 Federal Open Market Committee (FOMC) meeting -- unless hijacked by subsequent data or events in the interim. He clearly spelled out terrorism as an ongoing risk to which the Fed would respond.
Supported by the tame core CPI result, Greenspan was relatively upbeat on the topic of inflationary pressures, suggesting that they were "not likely to be a serious concern ahead." If this assumption was mistaken, he said the Fed would respond appropriately. While this was patently similar to his previous statements on the topic (see BW Online, 6/10/04, "Straight Talk from Greenspan"), its reiteration did reinforce the idea that the Fed could quickly catch up with larger rate hikes if it was in danger of getting behind the inflation curve.
He noted that the Fed had been wrestling with whether the effects of energy-price gains were transitory -- or if they were becoming entrenched in the economy. When asked whether the central bank would respond to higher energy costs, Greenspan concluded that they were "not yet a material factor." He did warn, however, that the Fed was closely monitoring the "indirect" effects of energy costs, should they harm world growth and effectively tax the U.S. economy.
On the economic front, the monetary sage also was upbeat, suggesting that the economy might, in fact, find a higher gear. Saying that there might be "another shoe to drop on the recovery," he noted that business capital investment had lagged behind what was normal at this stage and that net redemptions of corporate bonds compared to issuance suggested that there was plenty of room for business investment to grow.
Overall, Greenspan's prepared remarks and Q&A were less hawkish than the market anticipated, and he showed little inclination to disabuse the Street of its view that a quarter-point hike, to 1.25%, is coming for the fed funds rate on June 30 -- though likely nothing more than that.
His references to external shocks in the form of terrorism and the primacy of risk management suggest that he would prefer to drain the accommodative policy punch bowl slowly. Accordingly, Action Economics forecasts a string of quarter-point hikes, resulting in a 2% Fed funds rate by yearend or a 2.25% rate by early 2005. We expect the Fed to pause briefly in November for the Presidential election.
Wallace is global market strategist for Action Economics