Greenspan's Unfinished Job

Evidence is rising that the Fed will stay in the game longer than expected, certainly beyond today.
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What is Alan Greenspan's legacy? Is he the greatest central banker of all time? How will Benjamin Bernanke's tenure change the

Federal Reserve

modus operandi

?

Amid all of the thoughtful chin-scratching ahead of Tuesday's Federal Open Market Committee meeting, perhaps the most crucial question of all is getting short shrift: What is the likely path of monetary policy?

There seems to be a near-consensus view that the end of Greenspan's 18-year reign at the Fed will roughly coincide with the end of a 19-month long tightening campaign. The market has fully priced in Tuesday's expected 25 basis-point rate hike, which would take the Fed funds rate to 4.50%. But the majority believe one additional rate hike in March -- if even -- will certainly mark the end of the cycle.

Meanwhile, a small contingent, led by bond fund manager Bill Gross, believes the Fed will halt its tightening campaign Tuesday and perhaps cuts rates by the end of the year.

"We here at PIMCO have a viewpoint: short rates will be lower, as the Fed closes the ongoing tightening cycle at the end of this month and commences an easing cycle by the end of this year," Pimco managing director Paul McCulley wrote at the

firm's Web site earlier this month.

But the majority view (Pimco heavyweights included) about the extent of tightening has been persistently wrong since early June, when Dallas Fed president Richard Fisher's infamous "eighth inning" comment got folks speculating about the "last" rate hike.

The past six months have reminded Fed watchers that, just like baseball games, monetary policy can go into extra innings. Similarly, the "probably would not be large" phrase in the minutes of the Fed's Dec. 13 meeting guarantees nothing, despite conventional wisdom about the Fed's likely path. It's worth noting the fed fund futures now price in 80% odds of a 4.75% rate by the March 28 Fed meeting -- up from less than 50% a few weeks ago -- and 100% odds of that rate being reached on May 3.

Miles to Go Before They Sleep

There is a rising amount of evidence that the Fed will stay in the game for longer than expected, even if it pauses at some point to gauge the effect of its tightening so far.

Most prominently, the freshest economic data suggest that fourth-quarter weakness will be followed by a rebound.

Last week, an unexpected gain in December durable goods orders lent credence to the idea that

capital spending may continue to pick up this year. Also last week, an unexpected increase in new-home sales supported the scenario of a soft landing for the housing market.

Meanwhile, Monday brought news that consumer spending increased 0.9% in December, more than the 0.7% the market expected, and compared with an upwardly revised 0.5% in November.

The deflator for personal consumption expenditures, used by the Fed as a gauge of inflation, rose at a 2.2% annualized pace, above the 1.75% to 2.0% range preferred by the central bank.

That may spell goods things for consumption, but hardly seems to confirm expectations that the Fed will soon be going on hold.

Still, Tuesday's statement from the FOMC will likely comfort the optimists. Because Fed members will want to leave Ben Bernanke as much wiggle room (technical term) as possible, the statement is likely to be even more noncommittal than usual. In addition, the next FOMC meeting after Tuesday is two months away, an unusually long period of time between meetings.

"Lots of important info has yet to be released, and it would be nice to give

Bernanke and the Fed as much flexibility as possible to respond to all this," says Jan Hatzius, chief U.S. economist at Goldman Sachs.

A "dovish" statement will also likely refer to the softer economic data recently seen. Besides Friday's weak fourth-quarter GDP report, the December employment report showed the economy added only 108,000 jobs.

The Fed will likely soften its commitment to raise rates by signaling that additional rate hikes "may be needed," instead of saying they are "likely to be needed," as was said in previous statements, according to Hatzius. "The risk, though, is that the market will over-interpret the description as a hint that the Fed is just about done."

Such expectations might be contradicted as early as Wednesday, when markets will receive important updates on the manufacturing sector. The Institute for Supply Management's manufacturing index is expected to show a reading of 55.5 for January, down only slightly from December's 55.6. And on Friday, the all-important January employment numbers will be in, with the market expecting 250,000 new payrolls.

According to Goldman Sachs economists, warmer-than-expected weather brings upside risks to both of these numbers. They expect the ISM index at 57 and payroll growth of 300,000.

How much further the Fed moves above 4.75% is of course unknown, and will depend on the economy's performance in the months ahead.

But there are other convincing reasons to believe the Fed's work is not nearly finished. First, the central bank has merely returned interest rates to a "neutral level" after taking them to a 40-year low of 1% in 2003. It had ratcheted down rates to revive the economy from its post tech-bubble and post-September 11 slump.

According to Jim Paulsen, chief investment officer at Wells Capital Management, this helps explain why long-term rates have stayed low despite the Fed's tightening since last year. "It's been viewed

by the bond market as removing that post-depression discount. The Fed is only now beginning to tighten," Paulsen says.

Because long-term Treasury rates have remained low, so have mortgage rates, and this continues to encourage purchasing of new homes, as was seen in last week's pick up in new-home sales. Rates on 30-year fixed-rate mortgages have been falling since reaching a high of 6.32% in December to around 6.12% last week.

Although the outlook for the housing market and home equities is undeniably softening, Paulsen will "remain bullish on the economy and the consumer until mortgage rates start rising for real."

His forecast for the Fed funds rate peak is at least at 6%.

Wall Street may eventually celebrate this as supporting the idea that the economy and earnings growth will remain sturdy this year, as is Paulsen's view. But adjusting to the idea of higher rates may prove painful in the interim.

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

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