Friday, June 03, 2005

Loose lips, sinking bonds, and storms gather? 

There's some troubling activity occuring in financial markets right now. It's troubling for me, because I wrote a report last week that included a forecast on the Fed funds rate that the Federal Reserve targets. (And, unluckily, it won't be published until July. This is the bane of a forecaster's life.) Today's activity, coming after the job report, has Tim Duy wondering if the Fed has actually decided to stop raising interest rates. Duy writes like a Fedwatcher, so I'll simply paraphrase him: The markets and Federal Reserve officials seem to be talking differently right now. If he's right, this is very bad news.

The whole strategy of the Fed recently has centered on guiding expectations. The Fed has made its statements after FOMC meetings a critical passing of information from policymakers to the market. As Duy notes, new Dallas Federal Reserve president Richard Fisher made statements on Wednesday that suggested a much different statement than the last statement of FOMC. Here's what the Fed said:
The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.
Less than a month later, Fisher.

"I think we've room to tighten a little bit further," Fisher said, but, using a baseball analogy, added that the U.S. central bank is in the eighth inning of its tightening cycle and entering the ninth, and usually final, inning this month.

Fisher noted that the Fed had a double mission - to keep inflation at bay and to maintain economic growth. He said interest rates had to get to the point where "we are neither stimulating inflation or discouraging growth."

"We are not quite there yet. We are getting closer, and as to when we get there, stay tuned," he said.

Duy and others think Fisher is out of step, but the noise is nevertheless roiling markets.

In the past week, bond yields plunged when a rookie president of a Fed bank hinted that the tightening cycle might be in the "eighth inning," then soared when an old clubhouse veteran who's halfway out the door refused to comment on the remark.

It's gotten to the point where a few offhand comments by a couple of Fed backbenchers can have as much impact on real interest rates as an actual rate hike.

Greenspan is scheduled to speak twice next week, including testimony to Congress on Thursday, and the market will be very sensitive to what he says next. The upshot has been that the market is no longer favoring that the Fed will increase interest rates a second time this summer (everyone expects a quarter-point rise at the meeting June 29-30.) This could mean that the expectation is that growth in the second half of the year won't be that strong. I can't release all of what I've written, but this local event at Electrolux has gotten my attention, and the events on the market the last few days makes me wonder if the Fed sees it too.