There’s a higher degree of respect today for the old saying: Don’t fight the Fed.
In Fed Chairman Ben Bernanke’s first six months on the job, such counsel was thought to be of fading relevance. But the chairman’s verbal stumbles are gone while the Fed’s credibility is higher, thanks to Bernanke and company’s forecast that a slowing economy would complement lower inflation. So far, that prediction has proved to be accurate, and Wall Street couldn’t be happier.
In fact, yesterday’s decision by the central bank to hold Fed funds at 5.25% was widely expected. Fed funds futures have been predicting another pause for weeks.
But this new world order of respect for the institution that ultimately controls inflation’s path is contingent, as always, on what happens next. From an investor’s perspective, the future holds more than a few challenges, and perhaps some volatility in pricing because expectations in the present are fairly high and rising.
Investors seem inclined to believe that the so-called Goldilocks economy is assured–not too hot and not too cold. In this vision of future bliss, economic growth will slow enough to keep interest rates from rising, but growth will not tumble so much as to bring on a recession. Meanwhile, inflation will moderate to just the right level to stave off deflation while giving the Fed room to continue pausing and perhaps even begin cutting rates.
In a world where the yield curve is inverted, expecting perfection may be asking for more than the financial gods can deliver. A three-month T-bill currently yields 4.92%, about 20 basis points above the rate on a 10-year Treasury. Then again, perhaps this is the international signal that perfection is coming in economic and financial spheres. One has to keep an open mind in the new world order, even if we’re keeping one hand on our wallets.
In any case, jubilation dominates trading in stocks and bonds. The S&P 500 yesterday on an intraday basis probed heights last witnessed in February 2001, while the 10-year yield yesterday briefly dipped to its lowest (~4.71%) since March.
Some of the buying is inspired by the correction in commodities, notably energy. With the froth coming out of prices for oil, gasoline and natural gas recently, the money is being redeployed in stocks and bonds.
But amid all the euphoria that’s now sweeping Wall Street, it’s worth remembering that the Fed still has work to do. The core rate of inflation still remains too high to ignore. Meanwhile, labor costs seem to be perking up, delivering what may turn out to be a headache for monetary policy in the near future.
“All the wage data show an acceleration to one degree or another yet the policy makers do not acknowledge that” in yesterday’s FOMC statement, Mark Zandi, chief economist at Moody’s, told the New York Times today. “That is suggestive of a more dovish Federal Reserve. The small changes in this latest statement all suggest that the Fed will not be raising interest rates anytime soon. In fact, you can almost make the case that they are trying to drive expectations in the other direction.”
To be fair, the Fed’s statement did advise that “some inflation risks remain” and so “additional firming that may be needed….”
But for the moment, warnings fall on deaf ears on Wall Street.