The Market Shrugs as the Fed Fails to Surprise

As was widely expected, the Federal Reserve left the fed funds rates unchanged at 1.75% during its policy meeting today.

In the accompanying statement, the FOMC said:

"The information that has become available since the last meeting of the Committee confirms economic activity has been receiving considerable upward impetus from a marked swing in inventory investment. Nonetheless, the degree of the strengthening in final demand over coming quarters, an essential element in sustained economic expansion, is still uncertain."

Given that backdrop, the Fed said the risks in the economy between price stability and sustainable economic growth (i.e., inflation vs. recession) remain "balanced." Today's report that productivity rose 8.6% in the first-quarter to its highest level in 19 years likely encouraged, and apparently supports, that view.

Despite the FOMC's admission that monetary policy remains "accommodative" (i.e., easy), today's vote to leave rates unchanged was unanimous. That show of solidarity was notable, given today marked the first time a roll call was provided simultaneous with the policy statement.

While the Fed's decision to leave rates unchanged was widely expected, there had been some discussion that the central bank would change its risk assessment.

After having been solidly higher throughout the session ahead of the Fed's announcement at 2:15 p.m. EDT, major averages were recently losing ground although the Dow Jones Industrial Average was still up 0.7%.

The bond market's reaction was fairly muted; the price of the benchmark 10-year Treasury note was recently down 1/32 to 98 17/32, its yield unchanged at 5.07%. The 2-year note, which is most sensitive to changes in the fed funds policy, was recently up 1/32 to 100 16/32, its yield down to 3.11%.

True Confessions

Last night I penned a piece which mused, somewhat facetiously, about the possibility of a Fed ease today. Given my longstanding concerns about inflationary pressures, I wasn't suggesting the Fed should ease. Why, that would be like someone who has long warned about deflationary pressures encouraging the Fed to tighten.

Someone like Brian Wesbury, the Griffin, Kubik, Stephens & Thompson economist, who opined in Monday's Wall Street Journal that the Fed should "Hike Rates Now."

With no trace of sarcasm, Wesbury suggested the Fed "will be making a huge mistake" if it "gets lost on the debate about the strength of the recovery and decides to hold interest rates at current levels," as proved to be the case.

The Fed's 11 rate-cuts last year "ended the threat of deflation," he declared. "Now, the real fear is that the Fed will maintain its current policy stance for so long that inflationary pressures will begin to build."

Wesbury has been a longtime champion of "new era" economic theories and until very recently was writing about the ongoing threat of deflation -- including a Dec. 21 report entitled: "It's the Deflation, Silly."

So his worrying about inflation seems as unlikely at Ariel Sharon giving Yasser Arafat a big kiss. It's oil and water, dogs and cats, Manilow and Metallica. You get the picture.

In that Dec. 21 piece, the economist warned about "excessively tight Fed policy" and the accompanying "ravages of deflation" it was fueling. "The worst decline in corporate profits in 20 years, record corporate bond defaults and spreading bankruptcies are the result of deflation, and nothing else," Wesbury declared.

Wow. Nothing else? Not overly excessive capacity-building and lax lending standards during the boom years when Fed policy was incredibly accommodative? Not faulty and false accounting standards? Not belief in wrongheaded theories that the economy was no longer cyclical? Not greed? Nope, none of these things contributed to the recent recession and dearth of corporate profits, according to Wesbury. (In a conversation today, Wesbury said deflation was a "major" contributor to the woes of 2001, but not the only one.)

On Feb. 6, the economist penned a report entitled "The New Era's Death Has Been Greatly Exaggerated," in which he offered the following plea to Greenspan & Co.: "As productivity holds inflation down, we hope that this will restrain the Fed from over-tightening in the years ahead."

Of course, everyone is entitled to change their mind, and Wesbury's view of the economy has certainly gone through a metamorphosis.

In an interview today shortly before the FOMC's announcement, Wesbury said anyone surprised by his current stance on monetary policy "hasn't closely followed what I've said."

After the January durable goods report was released on Feb. 27, the economist said he "basically decided we'll have a very strong recovery" and soon thereafter revised his growth forecast to 4% or above for 2002 vs. 1.5% to 2% previously.

Indeed, on March 1, Wesbury wrote about having "a material shift in [his] thinking" and forecast "a sustainable V-shaped recovery." If the fed funds rate is not increased this year, he wrote, "inflationary pressures could eventually build in 2003."

Still, he "remain[ed] very optimistic on the path of inflation" and provided year-end targets of 12,000 for the Dow and 2500 for the Comp. (In retrospect, it appears Wesbury called the top in the economy and the stock market, at least short term. The most "V-ish" part of the recovery was in late 2001 and the first quarter of 2002, when the economy grew by 5.8%, while major averages peaked about a week after his report was published.)

Today, he stressed that "inflationary pressures aren't upon us" but worried that the Fed will make the same mistakes as in 1992-1993, "when it held rates too low for too long," resulting in 1994's bond market debacle.

The first part of Wesbury's change of view was the upward revision to his growth forecast. The second part was the combined message of strength in commodity prices (notably gold), in conjunction with accelerating weakness in the dollar in recent weeks and a steepening yield curve.

"Earlier this year, the dollar was still going up and commodity prices were still down," Wesbury noted, suggesting the idea he's late to the inflationary pressures story "sounds like sour grapes." (The dollar index peaked in late January and the Bridge/CRB Commodity Index bottomed shortly thereafter.)

"I want to see confirmation from all these things before I call a direction one way or another," he explained. "It wasn't until the last month you've seen every key indicator -- commodity, gold, the yield curve and the dollar all turning in the same direction. Somebody [else] may have forecast this would happen, but I didn't see confirmation it was correct until the last month or so."

Wesbury now expect the fed funds rate will rise to 3% by year-end and to 4.25% by mid-2003. Perhaps more notably, he's not alone in acknowledging the burgeoning inflationary pressures, although the Fed apparently remains blind to them.

>To order reprints of this article, click here: Reprints