The Fed's Bias Stance Causes More Confusion Than Clarification

The critical issue is not what the Fed should do, but what it will do.
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Editor's Note: Marc Chandler's Global Briefing column will not appear next week, as Marc will be on vacation. It will return on Sunday, Jan. 2, with an analysis of what's in store for 2000.

The

Federal Reserve

meets next Tuesday, Dec. 21. Few observers, if any, expect a rate change this close to the end of the year because officials are seeking to minimize potential volatility related to Y2K issues.

The market's interest in the meeting is really more related to procedural issues. The Fed has announced its policy bias as part of efforts to become more transparent. And yet experience has shown that rather than help clarify, the bias statement has confused market participants and appears to restrict the central bank's room to maneuver. The Federal Reserve itself is mostly at fault because officials themselves often attribute different meanings or significance to the bias statement. The market is expecting the Fed to clarify the meaning of the policy bias after the conclusion of Tuesday's meeting.

The first

Federal Open Market Committee

meeting of the new year is scheduled for Feb. 2. Looking at the fed funds futures strip, traders have almost fully factored in a 25-basis-point hike at that meeting. The market has also priced in a strong likelihood of another hike at the March 21 meeting.

Although thinly traded, the April fed funds futures contract implies an effective fed funds rate of 5.90%, which factors in 15 basis points of the expected 25-basis-point hike in March.

The market is also pricing in a third hike with a 50% probability.

The strength of the U.S. economy is the driving force behind market expectations for continued tightening of monetary policy. Recent data suggest that the U.S. economy is expanding at around a 5% to 5.5% pace here in the fourth quarter. It's not clear at this juncture how much of this activity is related to preparations for Y2K, which in effect borrows from Q1 growth next year. Nor can the Federal Reserve be sure.

At the same time, there could even be a post-Y2K consumption boom. Here's my logic. Many households will take out extra cash in the last week or so of the year, just in case Y2K proves more traumatic than is currently expected. Given all the hype, you can't blame people for being careful. Assuming there are no significant glitches, what will happen to that extra cash? Frankly, it's hard to envision people lining up at the ATMs to redeposit it. Rather, a good part of that cash may be used to take advantage of the post-Christmas sales.

Everything the Federal Reserve has done and said this year has helped raise market confidence that it will be pre-emptive in combating inflation. The rotation of the regional presidents to voting members on the FOMC suggests a slightly more hawkish stance than this year's composition.

In the new year, market participants should focus on real sector data, not on the monthly consumer and producer inflation measures. By the time inflation shows up in those gauges, the price genie is already out of the bottle. Ironically, the core rate of inflation (which excludes volatile oil and energy prices) rose less in 1999 than in 1998. The headline rate, due in a large measure to the dramatic rise in oil prices, is above last year's pace. Next year is likely to be the opposite, with the core rate exceeding the headline rate.

The Fed's guidance has been even more pointed. Of all the data the U.S. publishes on the state of the economy, the Fed appears particularly sensitive to those concerning the tightness of the labor markets. But here, the Fed seems guilty of selective use of statistics. The tightness of the U.S. labor market is mostly illusory. The 4.1% unemployment rate is more a function of the definition used than true labor conditions.

For example, 40% of women and almost 90% of senior citizens, a large number of minorities, immigrants and people with disabilities are excluded from the definition. Calculations by the

Bureau of Labor Statistics

suggest that under a more inclusive definition, the number of unemployed people between the ages of 16 and 64 is nearly 10 million. This means that the "real" unemployment rate is closer to 7% than 4% of the more restricted measurement.

Formerly retired men coming back into the labor force has been one of the underappreciated developments. Another factor that is often overlooked is that as senior employment increased this year,

Medicaid

spending fell for the first time for factors that include fewer hospitalizations than predicted.

There also seems to be the remnants of some class antagonisms as well. For example, the Federal Reserve, like other central banks, appears to have claimed for itself a role in how the productivity gains get distributed between employers and employees. The Fed appears to stand ready to prevent the latter from acquiring too large a share and, in doing so, to effectively seek to avoid a squeeze on profits.

In any event, for most market participants, the critical question is not what the Fed ought to do, but what it will do. And it seems clear that as much as some Fed officials talk about the new economy and the acceleration of productivity, the majority is still wedded to old

Phillips Curve

ideas about the trade-off between employment and inflation. They will likely act accordingly.

Marc Chandler is the chief currency strategist for Mellon Bank. At the time of publication, he held no positions in the currencies or instruments discussed in this column, although holdings can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

chandler.m@mellon.com.