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How Long Will the Fed Hold Out?

Overseas action and an improving labor market focus attention on the Fed's timetable.

The mainstream media and Democratic presidential candidates continue to focus on the "jobless recovery." But Wall Street is moving on to the ramifications of an improving labor market, including the potential for

Federal Reserve


sooner vs. later.

The labor market "remains weak" relative to its recent peak, but "the odds, however, do increasingly favor a revival in job creation,

Federal Reserve

Chairman Alan Greenspan said in a speech Thursday. In a separate speech, Fed governor Ben Bernanke reached similar conclusions.

In classic form, such good news for Main Street is cause for consternation among some Wall Street participants. Improving labor conditions, following recent evidence of strong economic growth, increase pressure on the Fed to tighten, even if both Greenspan and Bernanke argued to the contrary.

Concerns about rate hikes retreated after the Fed's Oct. 28 declaration to remain accommodative for a "considerable period." But they re-emerged Thursday as initial jobless claims fell to their lowest level since January 2001, with the four-week average hitting its lowest level since March 2001. Separately, the hours-worked component of the third-quarter productivity report rose for the first time since 2000's first-quarter.

Treasury prices fell notably, with the yield on the two-year note rising to its highest level in two months. The price of the benchmark 10-year note fell 17/32, its yield rising to 4.42%. The 30-year bond fell 30/32, its yield rising to 5.25%.

Stock proxies fared better, thanks to a late-day surge. The

Dow Jones Industrial Average

closed up 0.4% to 9856.97, while the

S&P 500

gained 0.6% to 1058.07 and the

Nasdaq Composite

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rose 0.9% to 1976.37. The close is the Comp's highest since January 2002, while the Dow and S&P ended a hair below multimonth highs established Monday. (In addition to the economic news and the Fed-speak, stocks were aided by robust earnings from


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, and strong October sales from


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The dollar rallied while gold fell fractionally.

One Man's Meat, Another's Poison

Clearly, the financial markets' near-term fate, and expectations for monetary policy, hinge on the outcome of Friday's employment report. Economists expect payroll growth of 65,000 and for the unemployment rate to remain unchanged at 6.1%.

But rate hikes this week by the central banks of England and Australia raise further questions about the Fed's timetable, although the European Central Bank left rates unchanged.

Notably, the Bank of England cited continued strength in consumer spending and housing prices as a rationale for raising rates. By such criteria, the Fed is woefully behind the curve: U.S. personal consumption is up nearly 6% on a year-over-year basis, existing-home sales hit at an all-time high in September, housing starts aren't far from July's 17-year high, and the Mortgage Bankers Association's index of new mortgage applications is at the highest level in a year.

Rightly or wrong, this has been the Fed's plan all along: Keep rates at historically low levels in order to spur continued consumer spending and strength in the housing market while corporate America recovered from the 1990s binge. Thursday may have been a preview of how Treasuries may react if market participants more seriously consider Fed tightening before next spring.

"As we see further signs of reflation, rates are biased higher," said Michael Ryan, chief fixed-income strategist at UBS. "We're underweight duration and think repricing risks are to the downside."

Still, Ryan believes the Fed will remain on hold until June and can afford to be patient, as Greenspan declared in his

speech Thursday. "We've had a string of decent economic data but still have relatively fragile global growth prospects, slack labor markets, ample capacity and little evidence of inflation pressure in finished goods," Ryan said. "The Fed doesn't need to raise rates."

Indeed, statistics such as the core consumer price index and the core personal consumption expenditures continue to show inflation subdued, even troublingly low. Additionally, capacity utilization remained under 75% through September.

However, I doubt most Americans would say inflation is nonexistent. Services costs were up 3.1% on a year-over-year basis, according to the September CPI report, due most notably to higher education and medical care costs. The average price of new homes is up 19% on a year-over-year basis while existing-home prices are up 7%.

Commodity prices also belie the Fed's balance of risk assessment. Gold prices are up nearly 20% in the past year while the Journal of Commerce-Economic Cycle Research Institute's Industrial Price Index is up nearly 33% on an annualized basis.

"Signs are clear inflationary pressures are building," said Brian Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson in Chicago, who also cited the dollar's weakness and the very steep yield curve. "These real-time market indicators are much better than lagging CPI or GDP or unemployment statistics

and are telling us monetary policy is too easy."

Wesbury expects the Fed will tighten at its March policy meeting rather than wait until April, as currently forecast by fed fund futures. He predicts fourth-quarter GDP will show 5% real growth and the unemployment rate will be below 6% by March. "The pressure

to tighten will be overwhelming and the Fed won't be able to ignore it," he said.

While a minority view on Wall Street, that's increasingly not a radical one: "The Fed is going to follow a responsible monetary policy," George Soros, chairman of Soros Fund Management, said on


television. "We are going to start raising interest rates."

In a similar vein," the only thing standing between where we are now and the first rate hike is a few months of solid job creation," Bear Stearns economists commented this week. "We continue to believe that we will see this in time for the Fed to hike interest rates at the March 2004 FOMC meeting."

At issue is how (and when) Wall Street adjusts to that possibility. The Treasury market could seize up, similar to what occurred this summer or in 1994. The stock market might consider tightening confirmation of the recovery or worry the Fed will pre-empt growth, depending on how dramatically Treasuries react and whether bullish or bearish sentiment holds sway.

Aaron L. Task writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.