A Subtle Shift at the Fed
By Michael Wallace
Following two days of deliberations by the Federal Reserve's policymaking committee, the central bank finally kicked off the long-awaited monetary tightening cycle on June 30, lifting the fed funds target rate from 44-year lows by a quarter of a percentage point, to 1.25%.
In a statement explaining its move, the Fed also pronounced that "upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters are roughly equal." Though keeping the monetary policy bias neutral was expected, some sleight of hand on its construction nearly went overlooked -- a reference to growth and price stability was forged back into a single sentence in the central bank's statement.
In recent previous statements, the introduction of disinflation language had caused the Fed to split the discussion about risks concerning those two issues. By putting them back together, the Fed has stealthily come full circle and put its brush with deflation behind it.
Another subtle change to the statement that was so similar to previous comments was the insertion of a potentially hawkish caveat: "Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability." That's Fedspeak for signaling how serious it is about keeping inflation in check.
Still, this was similar to Chairman Alan Greenspan's Senate confirmation testimony on June 15 that if the Fed is "mistaken" in its inflation forecasts, it will act accordingly. So the hawkish tone didn't take the markets by surprise (see BW Online, 6/16/04, "Greenspan: What, Me Worry?").
The June 30 statement also underscored that members of the Fed Open Market Committee, the Fed's policy-making arm, still see policy as accommodative, despite having raised rates in what is most likely just the first of a series of hikes in coming months. The pronouncement clearly gives the Fed elbow room to take larger policy steps, if required, but didn't mandate removing accommodation at anything other than a "measured" pace.
The bond market drew some comfort from the more detailed explanation of the Fed's view of inflation risks. Greenspan had previously said the central bank was closely studying the impact of high energy prices. In this regard, the FOMC articulated that "a portion of the increase [in energy prices] in recent months appears to have been due to transitory factors."
The Fed has obviously been encouraged by the 20% drop in crude-oil prices from highs above $42 a barrel on Mideast supply disruptions. Recall that Greenspan had fired a shot across the bows of energy speculators as well at a monetary conference in London on June 8, warning of a rise in "net long positions" in oil futures and options (see BW Online, 6/10/04, "Straight Talk from Greenspan").
Market reaction to the Fed's first tightening since June, 2000, (when the fed funds rate was at 6.5%) was fairly constructive. Treasury yields had already been pricing in a relief rally after the Fed had thoroughly telegraphed the move, with the 10-year yield sliding over 15 basis points, to 4.6%, from highs this week set in the aftermath of the higher-than-expected inflation numbers on June 28.
Heading into June payrolls data on July 2 and the long July 4 weekend, however, the bond market could pull in its horns somewhat. Wall Street finished with modest gains, and the dollar eased back, in line with the more dovish "transitory" spin on inflation risks.
Fed fund futures, the vehicle for investors to hedge against future interest rate moves, imply that the Fed's "measured" message has gotten across. The contracts have fully priced in another quarter-point move in August but diminished the odds of a larger half-point step. By yearend, the market is predicting the Fed will have a 2.25% target rate.
Wallace is global market strategist at Action Economics
Edited by Beth Belton