Bernanke Walks the Thin Line

The FOMC statement provides a little something for everyone, leaving markets relatively unscathed.
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Little changed in the FOMC's statement Wednesday, but the Ben Bernanke-led Fed accomplished the difficult task of providing something for each of its varying constituencies.

Bond market vigilantes took the policy statement as not hawkish enough, and stock market bears were similarly distraught. But the statement contained enough backbone to stem the dollar's recent decline and simultaneously provide hope to those expecting a pause at the June meeting. Given the breathless anticipation of the statement, the Fed deserves credit for crafting a statement that was all things to different people and didn't prompt major upheaval in the financial markets.

Of course, the Fed could be seen as having merely delayed the inevitable and leaving investors pretty much where they were prior to the March meeting. The debate now turns to whether the Fed will hike rates again in June or pause after collecting data.

"The Fed stated it will be taking its cue from the market more than it has in the past," says John Lonski, chief economist at Moody's Investors Service. "If forthcoming data is going to be inflationary and bond yields rise, the Fed tightens. If the market does not believe data indicates an increase in inflation risk, it will enter into a pause that may well continue into a stop."

The bond market, which is keenly sensitive to inflation, felt the statement didn't go far enough. The yield on the benchmark 10-year rose to 5.13% from 5.10% before the meeting.

"We

hope

the Federal Reserve will be an inflation-fighter and preemptively thwart off many of the mounting inflation pressures by raising its overnight borrowing target," says Richard Yamarone, director of economic research at Argus Research Corp. "But hope isn't a strategy, it's an emotion. In the event the Fed does sit sidelined, we believe the bond market will step-up and do the Fed's work for them."

Stock market bears were similarly distraught, even if the stock market itself had a fairly muted reaction to the statement and the recent trend of outperformance by blue chips continued. The

Dow Jones Industrial Average

barely eked out another six-year high, closing up 2.88 points at 11,642, now only 80 points off its all-time high of 11,722. The

S&P 500

was down 2.22 points to close at 1,322, and the

Nasdaq Composite

lost 17.51 points at 2320.

The Nasdaq was weighed down by

Cisco

(CSCO) - Get Report

and

Teva Pharmaceuticals

(TEVA) - Get Report

, while the Dow got its biggest lift from

United Technologies

and

Boeing

(BA) - Get Report

.

"The stock market seems to be shrugging it off, but overall, the markets are giving Bernanke a vote of no confidence as he is not taking heed of the message markets are sending -- that inflation is more of an issue it was March 28," said Peter Boockvar, equity strategist at Miller Tabak, who has been in the bearish camp of late.

But bulls like Ed Keon, chief investment strategist at Prudential Equity Group, saw another message. "I think the Fed will pause here," says Keon, noting the lag effect of monetary policy. "I still like stocks more than bonds and think we're on the path to a soft landing." Earlier this week Keon upped his allocation recommendation in stocks to 70% stocks, from 65%, his third such raise in the past month.

The Meaning of 'Yet'

On the question of a pause in the Fed's tightening campaign, the

May 10 statement only inserted the word "yet" to the key phrase from the March meeting, saying "some further policy firming may

yet

be needed to address inflation risks."

The statement goes on emphasize that any further moves will be data-dependent, and this language is slightly stronger this month than in March. "The extent and timing of any such firming will depend

importantly

on the evolution of the economic outlook as implied by incoming information." After the March meeting the statement said that "the committee will respond to changes in economic prospects

as needed

to foster these objectives."

On inflation, the FOMC statement says nothing new about commodities prices. It says growth is likely to "moderate to a more sustainable pace," and that the "run-up" in energy and other commodity prices has not had much of an impact on inflation, thanks to productivity gains.

But since March 28, commodities prices have steadily climbed with the price of gold rising from $572.20 per ounce on March 28 to $709.70 per ounce Wednesday. Among other commodities, copper has risen 53% in the same time frame, silver by 30.7% and platinum by 15.7%, according to Miller Tabak. Elsewhere, inflation pressures are mounting in the CPI and core PCE measures, which are riding at the Fed's self-proclaimed 2% comfort zone. Also, hourly wages have increased and the 10-year TIPS market shows an implied inflation rate at about 2.7% over 10 years, a one-year high and up from 2.28% in late December, notes Boockvar.

But the Fed's restraint in the statement this month does not necessarily mean it is ignoring that inflation pressures are building. Indeed, the phrase "some policy firming may be needed" -- even accompanied by the nebulous "yet" -- could be perceived as hawkish.

"The easiest way to indicate a significant change in the Fed's presumed path would have been to eliminate the forward-looking language at this point;" says Peter Kretzmer, economist at Bank of America. "The FOMC chose not to do so despite its more neutral posture. This decision indicates that rate hikes remain the default Fed action for now."

Kretzmer says his expectations of a June rate hike to 5.25% have now increased, as did such expectations in the fed fund futures market. Odds of a June rate hike rose to 50% vs. 40% prior to the FOMC statement's release.

The currency market was somewhat distracted by the U.S. Treasury Department's semi-annual report on foreign exchange, which also came out Wednesday. Nonetheless currencies also reacted as you'd expect -- hoping the statement was hawkish and focused on the fact it didn't indicate anything further about a pause. The dollar modestly strengthened against the yen and the euro after the minutes were released.

"The Fed has opted to avoid repeating Bernanke's dovish remarks from last month's Congressional testimony in order to stabilize any disorderly dollar declines," says Ashraf Laidi, chief currency analyst at MG Financial Group. "Using old central-bank parlance, the Fed opted for maintaining its 'tightening bias,' which is the responsible course of action considering uncertainty in energy prices and the dollar decline."

Speaking of Bernanke's communication style and substance, the Fed chief has been blanketed with criticism about his credibility since the Maria Bartiromo flap. By not trying to overtly prove anything in this statement, perhaps his credibility gets stronger.

"The statement was a subtle way of reminding the markets that the Fed is on the case, without unduly alarmist language about the inflation outlook," says Andrew Tilton, economist at Goldman Sachs.

To maintain the most flexibility possible means Bernanke reduces his chances of being wrong. When it comes to monetary policy, sometimes not being wrong is as good as being right.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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