Is the Market Getting Ahead of the Fed?

Bond futures signal rising expectations of further rate cuts. Chances are, however, that Greenspan & Co. will be in no rush to slash

By Rick MacDonald

Could the economy be sliding back into recession? The surprising weakness in the February employment report, released Mar. 7, combined with the ongoing drag of geopolitical uncertainty, has significantly increased market worries that the dreaded "double dip" could indeed happen.

And based on some recent market signals, bond players are acting as if they think they know what's coming next from the Federal Reserve. Take a look at the swings in the Fed funds futures contract, a vehicle for market pros to bet on future interest rate moves. Prices for the April contract have jumped from levels implying about a 20% chance that the Fed funds rate will be 25 basis points lower by that month to signaling over the last week nearly 50% odds. And the July contract is now pricing in not only a quarter-point easing but an additional 10% chance that rates could be 50 basis points lower by that month.


  We at MMS International believe that the market may be getting ahead of the central bankers' actual thinking. Instead, the more pertinent question is whether the Fed at its Mar. 18 meeting will opt to say risks are now tilted more toward economic weakness rather than inflation, given recent developments and market expectations.

We think the Fed will want to wait to see economic data for March to get a better idea of the extent to which February's numbers were depressed by weather-related distortions. The winter storm that hit the East Coast during the Presidents' Day weekend was one of the worst of the last decade. Comparable storms (in January, 1996, and March, 1993) had similar effects on economic data -- big drops in employment, retail sales, and industrial production, which subsequently recovered in the following month.

We would also emphasize that economic data still have shown little evidence that underlying trends have actually deteriorated over the last several weeks. While the 308,000 drop in February nonfarm payrolls was much worse than expected -- even assuming no impact from the weather -- the decline could easily be rationalized as payback for the surprising 185,000 jump seen in January, as well as a shortfall related to the call-up of nearly 200,000 military reservists to active duty.


  Other indicators support this view. The Fed's own Beige Book survey, a report using anecdotal evidence from the Fed's regional banks every six to eight weeks, released Mar. 5 showed that while conditions remain depressed, things had not changed dramatically from the previous report. Similarly, recent remarks from a number of Fed officials (see BW Online, 03/06/03, "The Fed Looks Beyond the Fog of War") suggest that the central bank has also not wavered from its view that a firmer recovery will take hold later in 2003.

Fed Chairman Alan Greenspan made this clear in his recent semi-annual testimony before Congress on the state of the economy. He indicated that he believed geopolitical concerns have put a considerable damper on growth but reiterated that these risks will inevitably dissipate.

This view suggests that the Fed sees current weakness as temporary, and thus, would be hesitant to ease again given how accommodative current policy already is. After all, rates are at 40-year lows across the board. Moreover, it indicates that the Fed may have doubts on whether monetary policy is an effective solution for the problem of geopolitical uncertainty.


  There is, however, one vital economic reading that has shown a notable deterioration: Consumer sentiment. But we would write off the weakness as stemming more from geopolitical concerns rather than fundamental developments (e.g., jobs and income), which suggests the impact on real spending could be negligible.

Overall, while the Fed is surely concerned about recent weakness in some economic data, the rise in energy prices, and the broader uncertainty of war, it's our view that Greenspan & Co. wants "more time for inspections" before deciding to act. Moreover, we believe that data for March and April will provide a much less threatening tone than the distorted updates of February.

MacDonald is a senior economist for MMS International

Edited by Beth Belton

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