Fathoming the Fed's Next Moves

Investors need to look beyond what Greenspan & Co. do with rates on Tuesday. The key to what's coming is what they say and how they say it

By Rich Miller

Ever since Hurricane Katrina tore through the Gulf region three weeks ago, financial markets have been fixated on a single question about the Federal Reserve. Will the destruction prompt Fed policymakers to pause in their 16-month-old campaign of interest rate hikes?

With Fed Chairman Alan Greenspan and his central bank colleagues due to meet Tuesday, Sept. 20, to map monetary strategy, a growing number of analysts expect the rate-setting Federal Open Market Committee to plow ahead with another quarter percentage point rate increase in the Fed funds rate, to 3.75%. Included in that group: former Fed Governor Laurence Meyer, Goldman Sachs (GS ) Chief Economist Bill Dudley, and Merrill Lynch (MER ) Chief Economist David Rosenberg, each of whom had previously expected the Fed to take a break from raising rates.

But all the focus on what the Fed will -- or won't -- do on Tuesday misses the main point. The key question isn't whether Greenspan & Co. raise rates on Tuesday. Even those few analysts who still expect the Fed to hold off from taking action admit that any pause in the hikes is likely to be temporary.

What's critical is how far the central bank will ultimately jack up rates. And to figure that out, it's more important to pay attention to what the Fed has to say about the economy and monetary policy than what it actually does with rates on Tuesday.

Here are some things to watch for:

Description of the Economy: Given the havoc wrought by Katrina, a major rewrite of this section of the Fed's statement is likely. Fed officials reckon that the economy can weather the hurricane's hit without tumbling into a recession. But they admit that the storm will cut into second-half growth, perhaps slowing it by a half to three-quarters of a percentage point. Economic growth through next year should be stronger, thanks to the tens of billions of dollars that the federal government will spend on reconstruction.

The inflation outlook is also murky. The steep rise in gasoline and other energy prices in the wake of Katrina will sharply boost inflation in the short run. But whether that proves transitory or results in a permanently higher level of inflation depends on a host of factors, including the stance of monetary policy, the amount of slack in the economy, and how consumers and companies respond to the energy shock.

Keys to look for include the Fed's descriptions of inflationary pressures and expectations. If it continues to characterize price pressures as "elevated" -- and judging by what officials have said in public and private, Fed officials will -- it's a sign that the central bank isn't ready to stop raising rates. As for inflation expectations, the Fed has called them "well contained." Any alteration in that assessment -- which is far less likely, in the view of most Wall Street analysts -- would also point to higher rates, perhaps sharply higher.

Balance-of-Risks Statement: Ever since May, 2004, the Fed has effectively said the risks to both economic growth and inflation are about in balance. It has, though, tinkered with the wording over that time. In its current iteration, the statement says such risks are roughly equal, contingent on "appropriate monetary policy."

Some officials admit that this robs the phrase of most of its meaning. After all, why would the Fed knowingly follow an inappropriate monetary policy? These officials prefer to junk that wording completely. Given all the uncertainties in the post-Katrina outlook, the arguments in favor of deep-sixing the balance-of-risks assessment could take on added weight.

Monetary Policy Guidance: As the Fed has raised rates steadily over the last 16 months, it has continued to describe monetary policy as "accommodative" and repeated Greenspan's belief that such accommodation could be removed at a "measured" pace. That has come to mean -- at least in the eyes of many in the markets -- that the Fed is all but committed to raising rates a quarter-point each time it meets.

Fed officials insist that isn't so and could take advantage of the uncertain economic outlook to dispense with the reference to "measured" rate hikes. That would give them added flexibility in carrying out monetary policy in the future. If the economy starts to look weak, they could skip raising rates at some future meeting. If inflation appears to be a significant problem, they could step up the pace of rate increases to a half percentage point without having to worry about blindsiding the markets.

The Fed's description of its monetary policy stance is particularly important. If it continues to characterize policy as accommodative, that means short-term rates have further to rise. The betting among most analysts is that's what the central bank will do. But if the Fed drops that characterization -- or modifies it, for example, by describing policy as "somewhat accommodative" -- this could be a sign that the central bank is nearing the end of its rate-hiking campaign.

Tuesday's meeting promises to be the most interesting in quite some time. If investors are to understand its true import, they'll have to pay attention to both what the Fed does -- and what it says.

Miller is a senior writer in BusinessWeek's Washington bureau

Edited by Phil Mintz

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