May 11, 2006
IN PAUSE WE TRUST
If the Federal Reserve's announcement yesterday on interest rates was intended to keep the market guessing, the central bank scored a home run.
The bond market went exactly nowhere yesterday, although at various points the fixed-income set was alternatively bullish and bearish. But when the dust cleared, the 10-year yield was unchanged at 5.125% at Wednesday's close.
In fact, shrugging one's shoulders is an eminently reasonable reaction to yesterday's Fed advisory. The rhetorical smoking gun from the FOMC is this line: "The Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information."
That's a slight change from the previous statement in March, which said that "some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance."
Translated: a pause in rate hikes is all but assured when the FOMC meets next in late June. That implies that Fed funds rate is at or near the typically elusive state of monetary affairs known as neutrality. In Goldilocks fashion, a neutral Fed funds is neither too hot nor too cold, or so we're told. Occupying this never-never land is said to neither promote growth nor retard it. Bernanke and company seem to be saying that we've now reached this state, and so further rate hikes are unnecessary, and perhaps even detrimental.
But there are no free lunches, even in the land of neutrality, which is fostering a bit more indecision than usual about what comes next, according to Ken Kim. An economist who watches the central bank for Stone & McCarthy Research Associates, Kim tells CS that decisions are getting trickier for the central bank:
Now that the Fed's closer to the perceived neutral rate, unfortunately there is more uncertainty as to where the stopping point is [for rate hikes]. Even though they have models and forecasts, it's hard to specify within a quarter percent of where you should be. I think we are at neutral. My personal opinion is that come late June, at the next FOMC meeting, they're going to pause and leave the Fed funds rate at 5.0%.
We also called David Resler, chief economist at Nomura Securities in New York. He thinks Fed funds are slightly above a neutral rate, but "not so far above it to create a serious risk to the economy."
In any case, Resler too expects a pause at the next FOMC meeting. In fact, he thinks the pause could last for a spell. He tells CS that there were three pauses lasting more than 12 months during Greenspan's tenure, and so it wouldn't be out of the ordinary to witness the Fed sitting on its monetary hands beyond the June meeting. Resler goes as far as to say that the next time the Fed changes interest rates from the current 5.0%, it will be one of lowering Fed funds.
"It is my belief that the Fed should stop tightening," Resler says. In support of that counsel, he points to the softening in employment data and housing numbers, which are "painting a very consistent picture of slowing demand." Although some pundits take issue with the outlook that the economy's winding down a notch, the Fed is nonetheless worried that growth will moderate. Keeping the expected moderation from something worse has become job one for the central bank.
The luxury of focusing on keeping growth intact, albeit at a slower pace compared to recent history, is dependent largely on the view that inflation isn't a material threat. What about the surge in energy prices? If higher energy prices were going to push up core inflation rates, we'd have seen it by now, Resler reasons. But there's no smoking gun, which is giving the Fed a green light to increasingly focus on managing economic growth and pull back a bit on nipping any future inflation in the bud.
The weeks ahead, leading up to the next FOMC on June 28 and 29, will either confirm or deny the wisdom embedded decision. For the moment, though, the inflation hawks are on the defensive. All that's left to do is take the Fed's advice and watch the date…closely.
Posted by jp at May 11, 2006 11:07 AM
Fed is raising rates to fight inflation. Treasury may be supporting decline of US dollar which adds to inflation as does higher energy cost.
What happens to dollar and US economy when oil is pegged to Euro vs. US dollar -- Marty Feldstein with Harvard University writes in "Financial Times" that value of dollar could fall by as much as 40%, if not more.
Posted by: Donald Holcher at May 11, 2006 1:24 PM