Updated from March 21
There's little doubt the
will raise rates by 25 basis points at Tuesday's Federal Open Market Committee meeting. The question in everyone's mind is whether two little words will remain in the statement accompanying the move.
In its previous six meetings, the Fed has raised rates by 25 basis points and indicated it could continue tightening monetary policy at a "measured pace" without derailing the economic recovery or fueling inflation.
But since the Fed's last meeting in February, these pressures have intensified. Commodity prices have kept surging, a weak dollar has continued to lift export prices, and job growth appears to be quite strong. No doubt, the measured pace language will have to go at some point, freeing the Fed to tighten the monetary tap more firmly, i.e., by 50 basis points at a clip. But will it drop the language Tuesday?
A majority of Wall Street economists expect the Fed to stick to the language at this meeting, but that it will drop it at its May or June meeting at the latest. Bonds firmed Tuesday ahead of the announcement, with the 10-year note recently up 5/32 to yield 4.50%.
The market, however, remained nervous Monday, just in case these economists are wrong. The
Dow Jones Industrial Average
fell 0.6% to 10,565.39, and the
lost 0.5% to 1183.78. The Nasdaq ended down 0.02%, to 2007.51, after trading as low as 1193.76.
Elsewhere, the dollar surged to a two-week high against the euro Monday and was also up against the yen on speculation that the Fed could drop the measured pace label. (It eased slightly Tuesday.) Comments from Hong Kong monetary officials warning Asian central banks to be cautious about moving out of the dollar also helped the greenback. In reaction, gold slumped more than $8 an ounce, or 1.8%, to $431.40.
The price of crude oil, which reached a new high of $57.50 per barrel last week, eased somewhat in Nymex trading to close at $56.62, down 10 cents for the session.
The Great Debate
High oil prices take time to transform into real inflationary pressures, but the market is worried that oil could derail the U.S. economic recovery.
Growth is there, Wall Street economists say, but there needs to be more evidence that it is here to stay, providing impetus for the Fed to maintain its measured pace. Economists have been looking at job growth so far this year as supporting the Fed's pace for at least two more meetings (Tuesday and on May 3). The February employment figures, which showed 262,000 new jobs added in the month, were just right for the so-called Goldilocks scenario of healthy growth that's free of excess inflation.
As the labor market tightens, inflationary pressures will mount, "but the one strong payroll report received over the past few months, for February, is not enough alone to shift the Fed's stance
yet," says Ian Sheperdson, chief U.S. economist with High Frequency Economics.
To take a stance contrary to Wall Street economists, let's look at the case for the Fed to drop the language this Tuesday. Tuesday's presumptive rate hike will bring the fed funds rate to 2.75%. That's still a low rate, indicating a very accommodative monetary policy. The Fed considers a neutral policy, which neither spurs nor restricts economic activity, to be in the 3% to 4% range.
Almost everybody agrees inflationary pressures are accumulating, but the timing of dropping the measured pace language depends, in part, on the lag time between the Fed's moves and their impact. The market has responded neither quickly nor convincingly to the previous six rate hikes. Long-term interest rates remained inexplicably low until mid-February, when Fed Chairman Alan Greenspan described this as a "conundrum."
Yields have been rising since then: On Monday, the price of the 10-year Treasury fell 4/32, its yield rising to 4.52%.
But last week came a sign that the credit markets had also been slow in responding to tighter (even if ever so slightly tighter) monetary policy.
issued a profit-warning and S&P downgraded its rating outlook on GM's staggering $45.7 billion debt. This triggered a flight out of emerging-markets and corporate debt markets into Treasuries.
According to Morgan Stanley chief U.S. economist Richard Berner, GM's woes in and of themselves are not representative of other industries. But "the tremors in the credit markets" in response to the GM news "underscore how little risk and how little volatility is priced into credit spreads," he says.
Furthermore, one glance at the housing market is enough to wonder how far we may be from (or already are in) a speculative bubble.
"All the signals are there to show that there's excess liquidity in the market," says Bill Mulvihill, senior economist with Claymore Advisors. In addition to the aforementioned, he also points to the decline of the dollar, commodities at 20-year highs, and nominal GDP growth at close to 7% for the first quarter.
"It's a telltale sign that the Fed is too easy," Mulvihill says. (Nominal GDP is real GDP plus inflation -- Claymore's forecast is for real GDP of 4.5% and inflation of 2.5%.)
Meanwhile, the market has been showing signs that it's worried about excess liquidity and inflation but won't do much about it until the Fed does. By dropping its measured pace language this week, the Fed would mostly be telling the market that it's in control of the situation. It would then have enough flexibility to react to changing conditions by its next meeting in May.
"What the Fed is really worried about is how much of a shock would a 50 basis-point hike be for the market, so this would be a good way of preparing everybody," says Mulvihill.
Last, but not least, is the core personal consumption expenditures (PCE) deflator. That indicator, which is the Fed's favorite, rose 0.3% in January, the biggest gain since early April 2002.
Winners and Losers
Monday's stocks on the move included several involved in mergers, with
striking a $2.8 billion deal to acquire
for $2 billion; and
for about $462 million in cash and stock. In addition,
Sunguard Data Systems
confirmed reports it is in talks to be acquired for up to $10 billion by a team of private equity investors that includes Silver Lake Partners, Texas Pacific Group and Thomas H. Lee Partners.
Among those names, Medicis fell 8% to $29.40 while Inamed rose 3% to $68.20; IAC shed 3% to $21.57 while Ask Jeeves gained 17.8% to $28.56; Avid fell 10.3% to $56.49 while Pinnacle jumped 15.5% to $5.74; finally, Sunguard soared 24.6% to $31.09.
shares tumbled 15% to $66.01 as drugmaker and partner
announced disappointing results in a phase III trial for a drug aimed at treating colorectal cancer, known as PTK787. The drug was seen as a potential competitor to
Avastin and news of its trial results helped send Genentech shares up 10.5% to $58.
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 invites you to send