The Fed: Not Exactly Neutral

Bernanke & Co. may have removed an explicit reference to rate hikes from the latest statement, but the policy focus remains on inflation

The market took its cue from the Federal Reserve on Mar. 21 and rallied sharply in the aftermath of the central bank's policy statement. After digesting the Fed's decision to leave the Fed funds target rate unchanged at 5.25%, traders saw a removal of a reference to an explicit policy tightening from its previous policy communiques—and a downgrading of the economic assessment by Ben Bernanke & Co.—as a signal to push stock and bond prices higher (see, 3/21/07, "Stocks Rally After Fed Statement").

But some market participants jumped on the change in wording as a shift in the Fed's policy bias toward "neutral," which runs counter to the reference in the short statement that "the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected." Did the Fed intend for the markets to view the statement as "neutral," even as it downgraded language that it felt may have weighed on the markets during this period of heightened volatility?

Something for Both Camps

Bernanke certainly attempted to appease both hawks and doves in the Fed's Open Market Committee statement, a near-impossible task. The economic outlook was downgraded back toward the December statement (data mixed, housing adjustment ongoing) in support of the dovish camp. But inflation risks were upgraded again as well (somewhat elevated) and labeled as the "predominant policy concern" for hawks, even as policymakers dropped the reference to "any additional firming," which had suggested the possibility of future rate hikes. Instead, the Fed's guidance on future policy adjustments was left more neutral, contingent on incoming inflation and economic data.

Specifically on the economy, the Fed downgraded its outlook on growth and housing: "Recent indicators have been mixed and the adjustment in the housing sector is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters." This stands in contrast to the January view that economic indicators were "somewhat firmer" amid "some tentative signs of stabilization" in the housing market, though it was telling that there was no reference to the "S" word—subprime. That's about as much a concession as the central bank was willing to make on recent housing concerns and asset-market volatility.

On the inflation front, the Fed upgraded risks: "Recent readings on core inflation have been somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures." This was a reversal from "core inflation improved modestly in recent months" noted in January. Moreover, the Fed made it abundantly clear that its "predominant policy concern remains the risk that inflation will fail to moderate as expected," even as it dropped "any additional firming" from the package.

More Market Worries

The statement's conclusion was left wide open, with the Fed allowing itself maximum latitude to adjust its stance going forward, depending "on the evolution of the outlook for both inflation and economic growth, as implied by incoming information." Call it one small step toward policy neutrality, but one giant leap in favor of the Fed's mandate to keep inflation in a box while still maintaining a wary eye on economic developments.

Interest-rate futures have recovered some significant ground since the January FOMC meeting, suggesting that implied market rates are much lower and that the Fed may be behind the curve on the economy. The housing market's cooling, increasing equity market volatility, a bounce in risk aversion, and the subprime lending implosion have all boosted market jitters.

Fed funds futures, a vehicle for market pros to bet on future interest rate moves, surged as traders jumped to the conclusion that the statement implied a neutral stance. Yearend rates are priced for at least a 25 basis point cut. However, policymakers clearly stated that inflation concerns are foremost.

A Second Sobering Look?

Interestingly, the elimination of the statement "the extent of any additional firming" brings the language back toward the original "balance of risk" concept which wasn't meant to prejudge the next rate move. We suspect that if traders get a whiff of stronger data for March, when the weather distortions to February's economic reports should unwind, they may start to rethink their notions of a Fed shift toward neutrality.

The market clearly exhibited an outsized reaction, with Treasury yields diving. The yield on the 10-year Treasury note slumped 7 basis points to 4.52% before stabilizing. The dollar plunged along with yields, while equities rejoiced and rallied more than 1% from pre-FOMC levels.

The Fed has left its options open to respond to incoming data, and remains predisposed to vanquish inflation before resuscitating growth. Policymakers likely are happy keeping their powder dry for now as they gauge their next move.

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