Yesterday traders on Wall Street showed their typical tendency to overreact to news events. The Federal reserve released the minutes from its Dec. 14 meeting in which members discussed the potential for inflation and signs of "potentially excessive risk-taking" in financial markets. The board then decided to raise rates a quarter point and keep the wording of their explanation essentially the same.
Here's why traders freaked out: The Fed's official policy statement issued on Dec. 14th said, "The Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal." That implies that members were just as worried that prices could fall as they were that they could rise. But the minutes of the meeting released Jan. 4 revealed that Fed members were really only worried about upward pressure on prices.
The minutes note, for example, "A number of participants cited the recent depreciation of the dollar on foreign exchange markets, elevated energy costs, and the possibility of a slowing in underlying productivity growth as factors tending to boost the upside risks to their inflation outlook, though, on net, they saw the risks to stable underlying inflation as still balanced."
Another worrisome comment: "Some participants believed that the prolonged period of policy accommodation had generated a significant degree of liquidity that might be contributing to signs of potentially excessive risk-taking in financial markets evidenced by quite narrow credit spreads, a pickup in initial public offerings, an upturn in mergers and acquisition activity, and anecdotal reports that speculative demands were becoming apparent in the markets for single-family homes and condominiums."
It is a shock to see that the Fed is more worried about inflation and speculative excesses than it has been letting on. But the fact that inflation may just be starting to rear its ugly head should be no surprise to investors -- in fact they should be relieved that the Fed isn't blind to this risk to the economy and markets.
Stocks have had a good run in the past three and a half months so some profit-taking here is a good thing. I expect the flow of positive economic news to continue in January and earnings season to be upbeat overall. Barring the usual crop of risks (geopolitical instability, higher oil, a plummeting dollar) and assuming inflation stays at bay -- there a vigilant Fed is the best defense -- the markets should be in good shape in the months to come.