The Fed's Stealthy Bias Shift
By Michael Wallace
As widely expected, thanks to Fed transparency, the Federal Open Market Committee lifted the federal funds rate by a quarter percentage point, to 2.75%, on Mar. 22. The Fed also retained a balanced risk assessment with regard to sustainable growth and price stability. Moreover, its policy mantra that "accommodation can be removed at a pace that is likely to be measured" remained intact. But that was only the cover story.
Beneath that scripted outline was a stealth shift in the underlying "rhetorical" balance of risk, as evidenced in the FOMC's outlook on price pressures and economic output. This shift suggests that the Fed could be on the brink of formally tipping the "official" balance to the upside as early as the next FOMC meeting on May 3.
The Fed supplemented its evolving view of inflation to include the caveat that "pressures on inflation have picked up in recent months and pricing power is more evident." It also upgraded output prospects to a "solid pace" from a "moderate pace."
This sleight of mouth made it clear that the "balance of risks" statement is in transition. The Fed stopped shy of formalizing that view to keep the markets calm without suggesting an immediate change to larger policy steps.
Indeed, the move appeared artfully designed to allow the Fed to have its cake and eat it, by taking an intermediate step toward creating more policy flexibility. In this way, Chairman Alan Greenspan has once again skillfully engineered a compromise that avoided any embarrassing dissent by satisfying both hawks and doves.
Upgrading either or both the economic and inflation balance statements without some foreshadowing would have been harsh medicine for the markets, which have already begun to come around to the Fed's thinking. The latest concerns about a credit event in the auto sector, given all the recent headlines on General Motors' (GM ) creditworthiness and the latest surge in the price of oil, likely supported the doves' call for a smooth transition and incrementalism (see BW Online, 3/21/05, "Pop! Goes the Auto Bubble"). Media stories on past crises of confidence following Fed tightening cycles and housing bubbles waiting in the wings likely had some resonance, which may be revealed in the next FOMC minutes on Apr. 12.
Yet the Fed continued to acknowledge the dual impact of the high cost of energy, though it was evidently reassured that economic growth continued to forge ahead and that energy wasn't feeding through into higher core consumer prices. It also reiterated that "longer-term inflation expectations remain well contained." This should allow the Fed to continue taking its time on reducing accommodation ahead, while keeping its options open to "respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability."
In that regard, the February headline producer price index (PPI) increased 0.4%, while the core index increased 0.1%, in line with expectations. Yet the figures left the overall index increasing 4.7% year-over-year, vs. 4.2% in January, and the core index rising 2.8% year-over-year, compared with 2.7% in January -- the strongest rate of core growth since November, 1995.
The risk is that the CPI will have further strength in March, given commodity price performance this month, and the Fed will have to continue to adapt its policy rhetoric accordingly. The other shoe to drop on Mar. 23 will be the February consumer price index (CPI), which we at Action Economics expect to rise 0.3% overall and 0.2% excluding food & energy, in line with median forecasts. Seasonal trends, commodities, and firmer food and energy prices suggest upside risk on the month, which could translate into year-over-year core inflation at 2.3%.
The markets woke up to this reality check from the Fed, with the bond market further unwinding Greenspan's "conundrum" with low long-term yields. The benchmark 10-year note surged 15 basis points, to 4.63%, despite the Fed's attempt at a subtle transition, while the 2-year note also vaulted by the same margin, to 3.83% -- the highest level in three years. This left the spread between the two instruments at roughly +80 basis points, given the parallel shift in yields.
MEASURED NO MORE?
The dollar rallied smartly, following the jump in yields and more hawkish Fed tone, while the stock market swallowed the news like a bitter pill. Fed funds futures even went so far as to price in 44% risk of a more aggressive half-percent move by June.
At Action Economics, we expect that the Fed will continue to raise rates in quarter-point increments for now, and will boost the Fed funds rate to an even 3% at the meeting in May, where it's also likely to drop the word "measured" and potentially clean up its balance-of-risk statement to reflect the true underlying state of affairs on growth and inflation. Barring some unforeseen shock to the economy, the central bank will still have its work cut out to normalize Fed funds in the 4% to 5% range.
Wallace is global market strategist for Action Economics