Old Fed Tune Is Music to Market - TheStreet

Old Fed Tune Is Music to Market

Stocks rally as the Fed keeps rates and language intact. Critics say it's fueling future inflation.
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Federal Reserve

succeeded in keeping everyone on Wall Street happy Tuesday, save the short-sellers and critics who believe it is too easy. Both equities and Treasuries rallied after the central bank left rates unchanged and reaffirmed that "policy accommodation can be maintained for a considerable period."

In recent days, there had been some

debate over whether the Fed would abandon that verbiage. By failing to do so, the Fed helped financial markets rally sharply.

"There was some growing expectation the Fed would try to come up with an exit strategy from 'considerable period,' but obviously it didn't," said Paul Kasriel, chief U.S. economist at Northern Trust Co. in Chicago. "I don't think there's any real constituency for Fed tightening," the economist said, save senior citizens attempting to live off fixed-income instruments such as bank CDs.

Indeed, the Fed announcement seemed to wipe out the recent angst among equity traders. Even as the Fed reiterated concerns that the risks of an "unwelcome fall in inflation exceeds that of a rise in inflation," the

Dow Jones Industrial Average

rose 1.5% to 9748.31, while the

S&P 500

climbed 1.5% to 1046.79 and the

Nasdaq Composite

jumped 2.6% to 1932.26.

Obviously, equity traders seem less concerned about deflation/disinflation than they were excited about the Fed maintaining a highly accommodative stance.

At 1.6 billion shares on the

Big Board

and more than 2 billion over the counter, volume was solid and up from recent levels. Advancers bested declining stocks by about 11 to 5 in both venues.

Stock proxies already were higher prior to the FOMC announcement, thanks to some upbeat news from

Taiwan Semiconductor

(TSM) - Get Report



(STM) - Get Report

. Both rose sharply to help push the Philadelphia Stock Exchange Semiconductor Index up 6.3%.

In addition, Monday evening's announcement that

R.J. Reynolds


will acquire the U.S. assets of

British American Tobacco

(BTI) - Get Report

fueled further excitement about M&A activity. Shares of RJR and BAT each gained over 13%.

A stronger-than-expected report on September consumer confidence and an upward revision to August's durable goods orders also helped create a positive tone early Tuesday. Such sentiments crystallized after the Federal Open Market Committee's

statement at 2:15 p.m. EST.

Apparently, fixed-income participants were braced for an even more optimistic economic assessment and hints of rate hikes sooner vs. later. After trading lower prior to the Fed announcement, the price of the 10-year Treasury ended up 17/32 to 100 15/32, its yield falling to 4.19%.

Although the euro fell to $1.1665 vs. $1.1747 late Monday, the dollar slid to 108.31 yen vs. 108.55. The Dollar Index rose 0.3% to 91.92.

The dollar's modest rise relative to U.S. equity and Treasury markets is a function of the FOMC statement, which "reinforces expectations that U.S. interest rates will remain unchanged for some time, thereby further eroding the dollar's interest rate disadvantage," according to Ashraf Laidi, chief currency analyst at MG Financial Group.

"Negative dollar sentiment is here to stay due to the combination of the Fed's determination to maintain low interest rates and the Administration's weak currency policy," Laidi continued. "This should also offset the growth differential" between the U.S. and the eurozone and U.K.

Laidi referred to Thursday's advance GDP report, which economists expect to show growth of 6%, in contrast to sub-1% in both the eurozone and U.K.

Pick, Pick, Pick

Despite the financial market's enthusiastic response, many observers were critical of the Fed's action (or lack thereof).

"I'm worried about interest rates trending upward in response to current policy," said William Tedford, director of fixed income at Little Rock, Ark.-based Stephens Capital Management, which runs about $700 million in intermediate-term bond funds.

Treasury Inflation Protected Securities (TIPS) are now pricing in a 2.25% inflation rate going forward, up from 1.5% a year ago, Tedford noted, predicting inflation will be closer to 3% in the coming year and "the bond market is not priced for that."

Tedford has long warned about the potential for inflation's re-emergence and thus been at odds with Fed policies. Still, his funds have outperformed the Lehman Intermediate-Term Bond Index year to date.

"I think more people are coming to my point of view

which is deflation is not the risk right now," Tedford said. "I think the trend will continue of interest rates trending upward despite the fact the fed fund rate is anchored at 1%."

As with Tedford, Northern Trust's Kasriel has long been critical of Fed policy and remains so inclined.

"Given the extreme slope of the yield curve, it seems to me the Fed is holding interest rates considerably below what might be the equilibrium level for rates," Kasriel said. "I think that leads to inflation in either asset prices or goods and services."

The economist doesn't believe inflation is an imminent threat but, among others, worries "the Fed could be sowing the seeds of higher inflation and will be behind the curve when it has to tighten."

Nevertheless, he doesn't believe the Fed will tighten until August 2004, in part because of a view Alan Greenspan is "planning his exit strategy;" i.e., trying to spur a robust economy before stepping down as Fed chairman in late 2004. Kasriel also believes Greenspan is "on the Bush re-election team," a suspicion shared by many observers. At the very least, the interests of the White House and Fed chairman are very much aligned.

Politics aside, his concern is that, by forestalling tightening, Greenspan's Fed "continues to perpetuate imbalances," most notably high levels of household indebtedness. "Personal bankruptcies are up, households are extended -- we're going to have to deal with that at some point."

Obviously, Tuesday was not the day for that reckoning.

Just for Kicks

The only change in Tuesday's FOMC statement vs. the one on Sept. 16 was the Fed's acknowledgement that the "labor market appears to be stabilizing" vs. "has been weakening."

Just for kicks, I did some quick analysis to see what's changed since Sept. 16. Heading into Tuesday's action, the Dow had risen 0.4% since Sept. 16 while the S&P had gained 0.2% and the Comp was off 0.2%.The 10-year Treasury's yield was unchanged at 4.26%.

On the other hand, gold prices had risen 3.5%, the Dollar Index was down over 5% and the Dow Jones-AIG Commodity Futures Index had risen 7.2%. Those gauges undermine the Fed's contention about the risks of falling inflation, although there was also a 38-year low reading in year-over-year core CPI on Sept. 16.

Meanwhile, there's also been the much-ballyhooed rise in September nonfarm payrolls, and a rise in consumer confidence to 81.1 from 76.8, while durable goods orders reversed August's dip (itself upwardly revised).

On the other hand, retail sales have weakened in the past month and many economists believe the third-quarter GDP growth was mainly a function of one-time tax relief.

This mixed bag of market indicators


explains why the Fed stuck with the status quo in its statement.

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

Aaron L. Task.