Parsing What the Fed Left Out
By Michael Wallace
The statements that accompany the Federal Reserve's policy meetings are carefully scrutinized by Wall Street, with key words and phrases poured over for possible hints as to future policy moves. But sometimes the Fed communiques are notable for what they don't say.
Take the Nov. 11 policy gathering. As widely expected, the Federal Open Market Committee (FOMC) voted to lift the Fed funds rate by a quarter percentage point, to 2.0%, a move thoroughly discounted by the markets well in advance of the November meeting.
Pundits had speculated that the Fed could introduce a number of issues that were relevant to the current policy debate: the sudden surge in the yield spread between inflation-indexed Treasury securities and conventional Treasuries, fiscal and current account deficits, and dollar weakness -- all hot topics in the market and all worthy of consideration. None of these items, however, made it into the Fed's postmeeting statement. We will now have to await the minutes from the November meeting, scheduled for release Dec. 16, to see if any were discussed.
Behind the scenes there was likely a debate on many counts among the assembled Fed governors, but the FOMC presented a united front. The central bank steadfastly asserted that monetary policy remains accommodative and that, along with robust productivity growth, this will continue to prop up the economy (see BW Online, 11/11/04, "Raising Red Flags About Productivity").
Alan Greenspan & Co. very subtly upgraded its views on output and the labor market, suggesting in the Nov. 10 statement that "output appears to be growing at a moderate pace despite the rise in energy prices." This was slightly more enthusiastic than "regained some traction" back in September. Likewise, policymakers acknowledged the strong October payrolls report, noting "labor-market conditions have improved." Note the removal of the modifier from the "improved modestly" last time around.
The Fed's reference to inflation was equally circumspect, with the assertion that "inflation and longer-term inflation expectations remain well contained." In September, the Fed had stated that "inflation and inflation expectations have eased in recent months." Again, the Fed appears to have hedged its bets subtly to the upside on both the economy and inflation, heading toward 2005. Indeed, it has gone to great lengths to refrain from alarming the markets while there is still some perceived vulnerability in the economy.
Were it not for this perception that something is still amiss in the economic picture, the Fed would not have retained its balanced view of the risks to sustainable growth and price stability. Indeed, this is consistent with its view that "policy accommodation can be removed at a pace that is likely to be measured."
Market reaction was varied, with a relief bid in the Treasury market based on the fact that the Fed was not overtly hawkish on inflation. The yield on the benchmark 10-year note settled at about 4.24%, moving off earlier session highs of 4.28%. The stock market finished mixed in light-volume trading. The dollar stabilized after hitting record lows against the euro of $1.3005 at one stage.
Fed funds futures, a trading vehicle for market pros to bet on future interest-rate moves, continue to imply 80% odds that the Fed will continue its program of measured rate hikes through the end of the year, with near 50/50 odds that it will follow up again in early 2005.
This is of a piece with our view at Action Economics that the Fed will continue to nurse rates higher until it reaches a 3.5% to 4.5% zone, for which it might claim policy neutrality -- where rates are neither too accommodative nor too high to choke off economic growth -- unless the data changes dramatically in the interim. We also would not rule out larger policy steps if growth or inflation delivers upside surprises next year.
Wallace is global investment strategist for Action Economics