Between the Fed's Fewer Lines
By Michael Wallace
Alan Greenspan may have decided it was time to clean up some clutter before leaving office. With just one meeting left before the Federal Reserve chief hands over the policy reins in February, the central bank issued a streamlined statement following its Dec. 13 policy meeting -- including the removal of language that policy is "accommodative."
On top of yet another quarter-point increase in the fed funds target rate, the Fed's policy-setting arm, the Federal Open Market Committee, overhauled its post-meeting statement to account for the 3.25 percentage points in cumulative tightening since the current cycle began 1 1/2 years ago to the current 4.25%. It appears that the outgoing Fed boss wished to clear away some linguistic baggage for incoming Chairman Ben Bernanke. In a housekeeping move, the Fed dropped the entire reference to "monetary accommodation, coupled with robust underlying productivity," while asserting that "some further measured policy firming is likely to be needed."
This move appears to have the dual purpose of putting financial markets on notice that the central bank has entered a more neutral policy footing, while at the same time alerting Wall Street that further rate increases may still be ahead (see BW Online, 12/13/05, So Where's the Economy Going Now?").
The Fed has been justified in looking past the temporary effects of the late-summer hurricanes, and it has since been vindicated in its view that productivity and GDP growth would remain resilient. In this context, another omission was telling: The Fed dropped its reference to "robust productivity." A more hawkish interpretation of the new statement could be that by dropping the productivity reference," the central bank sees the phenomenon as more trend-like -- and less likely to cap inflation.
Cumbersome references to the impact of Katrina and Rita -- and robust productivity -- on growth were stripped down or abandoned altogether, in favor of a more lean economic assessment. The Fed trimmed the economic outlook to: "Despite elevated energy prices and hurricane-related disruptions, the expansion in economic activity appears solid." We at Action Economics would certainly agree with this interpretation.
The FOMC's previous heavy-handed references to the outlook on inflation were honed to: "Core inflation has stayed relatively low in recent months, and longer-term inflation expectations remain contained." Yet the committee also qualified its rationale for remaining on a tightening footing. It cited "possible increases in resource utilization as well as elevated energy prices [as having] the potential to add to inflation pressures."
Clearly, the Fed will remain vigilant to maintain the rough balance of "sustainable economic growth and price stability." Financial markets will have the chance to gauge the Fed's success in this regard with the upcoming consumer and wholesale price reports for November (see Slide Show, "The Year's 10 Worst Predictions").
After the Dec. 13 announcement, fed funds futures, a vehicle for market pros to bet on future interest rate moves, rallied, along with the Treasuries and stocks. Apparently, the markets interpreted the removal of the "accommodation" reference to mean that the policy endgame is approaching. Yet the funds market remains priced for a quarter-point hike on January 31, 2006, consistent with the phrase that "some further measured policy firming" is likely to be needed. The market is back to about a 50-50 stance that newly minted Chairman Bernanke will hike another quarter-point -- to 4.75% -- at his first policy meeting on Mar. 28.
Led by shorter-dated issues, Treasury yields initially plunged several basis points after the statement was released, but soon found fresh equilibrium as the Fed telegraphed its intent to remain on track with measured tightening for the time being. The yield on the 10-year note dove 5 basis points, to 4.51%, before rebounding slightly, while the yield curve -- the spread between the 2-year note and the 10-year note -- initially steepened before steadying.
GOING IN STYLE.
Other markets offered their interpretations of the Fed meeting. Equities drew some strength from the view that the Fed cycle was nearer to a top than before, while the dollar weakened on the presumption that the rate of change on interest rate differentials would slow.
We at Action Economics look for one more hike from the Fed at the Jan. 31 meeting, with potential for the "measured pace" phrase to be jettisoned as well. That would leave Greenspan in a position to declare victory on inflation as his crowning achievement before passing the baton. And that would put Bernanke in a position to reassess the policy outlook in 2006 before putting his own stamp on the beginning of a new era later in the year.
Wallace is global market strategist for Action Economics