Market Looks for Tightening Bias to Reaffirm Fed's Cred

If tomorrow's FOMC meeting doesn't signal a bias toward higher rates, the market will frown at the Fed's perceived blitheness on inflation.
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This was supposed to be a no-brainer. Before Friday's

Consumer Price Index

report, predicting the outcome of tomorrow's

Federal Open Market Committee

looked easy. There were a few outliers, but the bulk of the market wasn't expecting any action from the committee.

Now it's a crapshoot. Many now believe, based on several factors, that the

Fed

will adopt a bias toward raising interest rates at this meeting. The bond market, which plummeted on Friday, has adjusted itself for this possibility. Such an action would bolster the Fed's credibility because it would convey a collective concern over rising inflation.

Still, others believe Fed Chairman

Alan Greenspan's

cautious-sounding

speech two weeks ago serves as "virtual policy," since he successfully jawboned interest rates higher. They think the recent rise in interest rates will be enough to slow growth in the housing and lending sectors, as well as hold back gains in the stock market.

"The phrase we've been using is, they don't want to appear asleep at the switch," said Carol Stone, deputy chief economist at

Nomura Securities

, who believes the Fed will change its bias. "It may be that this is passing, because we had overdue price increases that hit all in same month. Still, I think the Fed governors and presidents don't want to appear that they're ignoring it."

A survey of 30 dealers conducted Monday by

Thomson Global Markets

indicates that 62% believe the Fed will shift to a tightening bias tomorrow. Strategists believe such a move would maintain the Fed's standing within the financial markets, specifically the bond market.

Checking for Bias
Fed funds rate vs. 30-year Treasury bond over five years

This tactic would go a long way for the FOMC. A bias toward tightening is essentially a statement telling the market that the Fed is inclined to raise rates at one of the upcoming meetings. It demonstrates that the Fed is willing to act pre-emptively to reduce the risk of inflation, even if it doesn't hike rates. Last year the Fed held onto a tightening bias for several months without changing policy.

Interest rates have risen sharply during the last few weeks, and many believe that Friday's CPI and

industrial production

reports cannot be ignored. Not moving would give the impression that the Fed is ignoring what the market perceives as growing signs of inflation.

The CPI rose 0.7% in the month of April. The core rate rose 0.4%, helped along by strong increases in the housing, transportation and medical costs components of the CPI. Several other recent economic reports point to a recovery in demand in the manufacturing sector. Industrial production is rising at a year-over-year rate of 2%, the highest since last October. The

Chicago Purchasing Managers Index

, a measure of sentiment in the Midwest manufacturing region, is at its highest level in more than four years.

Energy prices continue to strengthen -- the price of crude oil has increased more than 50% this year. And while other commodities haven't rallied with the fervor of crude oil and natural gas, they're no longer in free-fall. Stabilization in commodities supports the idea that the global market is on its way to recovery, and the disinflationary pressures that enhanced the U.S. economy are eroding.

What, Fed, Worry?

The market isn't entirely convinced that the Fed should move to a tightening bias tomorrow. One month does not inflation make, strategists say. Several factors combined to cause the largest gain in the CPI in nine years, such as erratic tobacco prices and a swift rise in apparel prices after several months without gains.

Recent adjustments to the CPI may have added a bit of volatility to the monthly data, so it's become more important to look at long-term trends. On a year-over-year basis, the core CPI, which excludes volatile energy and food prices, is rising at a 2.2% rate, the same as in April 1998. Productivity rose 4% during the first quarter, while unit labor costs rose just 0.3%. While anecdotal evidence points to recovery in manufacturing, that sector is still shedding jobs and wages are only increasing at a year-over-year rate of 1.9%.

"The strong productivity growth numbers, the lack of a sustained rise in commodity prices, the deceleration of labor costs and the lack of bottlenecks in the supply chain trump the 0.7% CPI number," said Ken Mayland, chief economist at

KeyCorp

in Cleveland, who thinks the Fed will stand pat.

In his public engagements, Greenspan's been most concerned about the labor markets, maintaining that productivity gains and the dwindling pool of available workers will at some point lead to a rise in wage pressures. The household unemployment rate is currently 4.3%, but wage pressures have not materialized. The increase in productivity without a concurrent rise in wages or prices is at the heart of the debate between those proclaiming this a new era and those who believe the global recession and low interest-rate environment are temporary factors.

Greenspan has acknowledged the improvements in productivity, and he and the rest of the committee have been reluctant to raise rates. But the market will be looking for a sign that the Fed is attuned to the potential rise in inflation. "Their credibility is completely the question," Stone said.