Fed's Long-Term Path Still Unclear

'Everybody' agrees what the FOMC will do when it meets. Beyond that lies a crucial debate.
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With another one-quarter point rate hike all but assured on Wednesday, the question for investors remains, just how far and how fast will the

Federal Reserve

keep moving? Is a pause in the offing, perhaps because the economy is weakening, as the 10-year Treasury note seems to be signaling? Or is an acceleration of rate hikes in the wings, as low long-term rates (including mortgage rates) continue to stimulate the economy and fuel inflation?

For the outcome of the Open Market Committee's two-day meeting, starting today, few are predicting that the Fed will veer much from its prior tactic of 25-basis-point hikes or its boilerplate explanation of the state of the economy. The Chicago Board of Trade's fed futures contract is pricing in a 96% chance of a 25-basis-point hike, with just a 4% chance of a 50-point move as of Monday's close, according to the exchange's Web site.

The Fed's last assessment stated that the risks of inflation -- or "price stability" in Fed-speak -- and a slowing economy, or "sustainable growth," are balanced. Also, the Fed has been saying that its fed funds rate is still low enough to stimulate the economy -- that it "remains accommodative." And most importantly, the central bank isn't expected to alter its forecast that the pace of future rate hikes is "likely to be measured."

The meeting could be "one of the least interesting in recent memory," according to Lehman analysts Ethan Harris and Joseph Abate, who also note that the Fed's hikes thus far have had "remarkably little impact" on the markets.

Indeed, for five consecutive meetings starting in June, Chairman Alan Greenspan and his colleagues have raised the central bank's benchmark short-term interest rate by one-quarter of a percentage point. The 150 basis points of total tightening have pushed up short- and intermediate-term interest rates, but long-term rates have actually fallen since the Fed embarked on its tightening cycle.

Beyond the Expected

So what happens next, assuming the Fed does the expected this week?

With the fed funds rate highly likely to be at 2.5% after Wednesday, Jeffrey Gundlach, manager of the

(TGLMX) - Get Report

TCW Galileo Total Return Bond Fund, says a pause is on the horizon, even if the Fed doesn't give any hint of such a move this week. Pimco's first-quarter outlook had a similar prediction. On the other side of the debate, Stephen Roach at Morgan Stanley sees tightening as far as the eye can see, or at least until the fed funds rate approaches 4.5%.

Gundlach, whose fund gained 5.2% last year, about 1% ahead of the Lehman Brothers Aggregate Bond Index, says the Fed could stop when the funds rate hits 3%. "The economy just isn't that strong, and inflation is still battling with deflation," he said. "I don't think you're going to see the Fed get more aggressive. It's a question of when it's going to stop."

Recent data points appear to bolster Gundlach's case. Last Friday's fourth-quarter GDP report showed annualized growth of just 3.1%, and Monday's core personal consumption price index, a Greenspan inflation favorite, showed just a 1.5% gain over the past year. There has been some controversy over whether a Canadian trade data error might force a revision to the GDP report, but the impact of the error isn't yet clear.

That view is consistent with the big dog in the bond fund business, too. Pimco's first-quarter outlook projects that the Fed will stop tightening by the time the fed funds rate reaches 3%. A lack of pent-up consumer demand, modest corporate investments and a slowing housing market -- along with the Fed's previous rate hikes -- will all act as a drag on the U.S. economy and prompt the Fed to hold up, Pimco says.

Ever the contrarian, Morgan's Roach says "phooey" to that. Investors are "largely unprepared for some big changes" this year, he says, including more Fed hikes.

Or put more succinctly by


contributor David Merkel, the Fed will keep raising rates until something breaks, which in this case could be the housing market. Minutes of the Fed's December meeting showed that "some" members of the Open Market Committee were worried about "signs of potentially excessive risk-taking," such as rich corporate bond prices, rapid real estate price gains and a surge in IPO and M&A activity.

Interestingly, both Roach and Gundlach agree that the time has come to dump high-yield and emerging-market bonds, two of last year's best-performing sectors.

Gundlach says valuations have become too rich, and with the economy slowing, the fundamentals will be deteriorating. "You've got a recipe for trouble," he says.

Roach says the issue is those nasty hedge funds that have leveraged up by borrowing at historically low U.S. rates (thanks to the Fed) and invested in longer-term and riskier assets, be they domestic junk bonds or foreign securities issued by less-than-blue-chip countries.

"In 2005, the Fed is going to take the candy away," he wrote on Monday. "This points to a likely unwinding of a multitude of carry trades that have driven spreads on risky assets to unbelievably low levels."

History shows that Roach's view is often the case. In 1999 and 2000, the Fed helped pop the Internet bubble, and in 1994 it manhandled a host of derivatives-packed carry trades. As previously noted, after last year's tepid response to the Fed's moves, complacency has only increased. It may be that 2005, not 2004, will more resemble 1994.

In keeping with TSC's editorial policy, Pressman doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send

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