The Fed's Act II: Repeat Act I
By Michael Wallace
It seems appropriate that the Federal Reserve's latest policy announcement came on Feb. 2 -- Groundhog Day. Like the central character played by Bill Murray in the movie with the same name, investors and market watchers who read the central bank's policy statement issued after its two-day meeting must have gotten a sense that they'd seen this all before.
And they'd be right. Similar to its last meeting on Dec. 14, the Fed slavishly fulfilled market expectations by lifting the Fed funds rate by a quarter-point increment (it's now at 2.5%) and kept to its "measured" policy schedule. What was remarkable in the statement: The near-absence of any alteration in the boilerplate language from the one issued Dec. 14 with respect to policy, the economy, and inflation.
PRICE STABILITY. That's no accident. Due to relentless efforts at transparency in January, the Fed's Feb. 2 decision came as little surprise to Wall Street. The overall balance of risks with respect to "sustainable growth and price stability" remained "roughly equal." The entire extent of the Fed's fine-tuning was the removal of the word "earlier" from the phrase "despite the (earlier) rise in energy prices," a sensible change as elevated energy prices are still with us -- but scarcely noteworthy.
More than anything, the status quo suggests that the Fed is comfortable with the impact of the present policy course on market yields, especially with rates at the long end of the yield curve bucking the policy-tightening trend and remaining at very low levels relative to rising short-term rates.
Though minutes from past Fed policy meetings revealed that some members found the "flattening" curve trend curious and perhaps indicative of either excessive risk taking or lower growth expectations, others such as Minneapolis Fed President Gary Stern have aptly concluded that it's a function of the Fed keeping inflation expectations well-anchored. In other words, the Fed is enjoying the fruits of its own transparency.
PARSING OPINIONS. Left in the Feb. 2 communiqué from the FOMC were the familiar references to accommodative monetary policy, robust productivity, moderate output growth, and gradually improving labor-market conditions. Importantly, growth and price stability were seen remaining roughly equal for the next few quarters, while underlying inflation remained low. The committee foresees future policy tightening at a "measured pace" and retained its right to respond to any changes in economic prospects.
The behind-the-scenes debate on whether the Fed should set an inflation target wasn't reflected in the statement. But it will provide some valuable insights into board dynamics on Feb. 23, when the minutes of the Feb. 2 meeting are released. The full spectrum of Fed member opinions on policy, the economy, and inflation will then be thoroughly digested before the next meeting on Mar. 22.
Treasury market reaction on Feb. 2 was blunted by the lack of change in the statement, with curve flattening -- i.e., yields rising on shorter-dated issues while falling on longer-dated ones -- resuming after the green light from the Fed. This kept the shorter two-year yield supported above 3.3%, even as the figure on the benchmark 10-year note moved below session lows of 4.14%, and the 30-year held below 4.6%. The dollar remained in a trading range ahead of President Bush's State of the Union address, while the equivocal stock market barely managed to hold a bid.
NO SEISMIC SHIFTS. Wall Street's attention will quickly turn to upcoming key data releases, which include fourth-quarter productivity on Feb. 3 and the January employment report on Feb. 4.
It would take large changes in these data to prompt Fed Chairman Alan Greenspan to signal any significant policy-bias shifts in his semiannual testimony to Congress in the middle of this month. Greenspan will also address the U.S. current-account deficit on Feb. 4, though he's not likely to wander from that topic.
We at Action Economics expect the Fed to continue to take incremental policy steps into the summer, at which point it can survey the economic landscape once more and reappraise its handiwork -- after it has moved the Fed funds rate to 3%.
Wallace is global market strategist for Action Economics