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The

Federal Open Market Committee

kept the bond market intact this week with some linguistic legerdemain, vowing to hold interest rates down for a "considerable period" while quietly signaling that inflation had moved up on its enemies list.

Attentive Fed-watchers could see it coming.

"The probability of an unwelcome fall in inflation has diminished and now appears roughly equal to a rise in inflation," the FOMC opined Tuesday, while leaving its target interest rate at a 45-year low. With every asset market in the country keying on the "considerable period" language, this stealth tweak got a potentially risky job done.

In the past, any time the Fed de-emphasized disinflation, it has thrown the bond market into fits. This time around, after a reflex selloff, bonds held their own, with yields on the five- and 10-year notes actually falling slightly Wednesday. Heavy selling of yen by the Japanese central bank also helped drive demand for the bonds, as many traders expect it to use its dollar proceeds to buy Treasury notes.

That the Fed was inclined to tweak the inflation zeitgeist should've been apparent to those with their eye on the right data sets: metals commodity prices and U.S. manufacturing activity. Among all the favored indicators, these are among the most accurate in divining Fed policy.

The Industrial Metals Price Index measures the price of commodities used in global manufacturing such as aluminum, copper and zinc. Over the past 20 years, the index has risen sharply three times, and on each occasion the Fed has raised interest rates.

"Industrial metals price inflation is an indicator of manufacturing growth," said John Lonski, managing director and chief economist at Moody's Investors Service. "The current upsurge is the fourth major upsurge since the early 1980s, the other instances being in 1987-88, 1994 and 1999-2000. In each instance, the Fed tightened." Without Fed action, metals prices will probably continue to rise.

Metals prices have been a good proxy for global economic output, specifically in manufacturing. In each instance, the upsurge in metal prices was accompanied by a strong performance in U.S. manufacturing. But Lonski believes the latest rise may be more immediately attributable to industrial activity in Asia. He called this an "oddity," noting that the recent strong Institute for Supply Management (ISM) numbers notwithstanding, there has not yet been a proportionate upturn in U.S. manufacturing.

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Given still-soft employment in the U.S. and intense competition from Asia, it is not certain that the Fed's rate-hike schedule will correlate to higher metals prices to the same degree it has in the past. In fact, the Industrial Metals Index surged 24% between October 2001 and February 2003, a period in which the Fed dropped its target rate by 125 basis points.

Since February, however, metals prices have risen 31%. In the 1993-94 period, prices grew 43% and the Fed responded by raising rates 250 basis points to 5.5%. When metals prices grew 35% in 1999-2000, the Fed raised rates 175 basis points to 6.50%.

The fact that U.S. manufacturing sector is lagging relative to Asia and still losing jobs is probably why the Fed has held off this time around. In addition to higher metals prices, Lonski said, the Fed will be looking closely at capacity utilization. If the utilization rates climb every month between now and March, he expects a "nominal lifting of the federal funds rate by May."

The ISM released its semiannual economic forecast for U.S manufacturers today. Its survey of purchasing and supply executives shows that U.S. manufacturers expect to grow production capacity 3.8% in 2004. They expect to achieve this primarily through offering more work hours to existing personnel and adding new plants and equipment. These executives also expect capital expenditures to rise 3.2% in 2004.

U.S. manufacturers expect these expenditures to translate into sales. Business revenues are expected to grow 5.8%, led by electronic components and equipment, as well as fabricated and primary metals. Based on these numbers, 47% of U.S. manufacturers expect higher profit margins by April of 2004, an 11% rise vs. the last survey taken in the spring of 2003.

While manufacturing and related commodities prices are moving up, the Journal of Commerce points out that another leading indicator of Fed action -- inflation -- is actually declining. The Economic Cycle Research Institute's Future Inflation Gauge dropped to a one-year low in November. While manufacturing is picking up, analysts said that inflationary pressures are being tempered by a rapid decline in mortgage originations.

Of course, it has been housing and the U.S. consumer that have saved the U.S. and world economies from even deeper trouble over the past few years. As signs solidify that U.S. manufacturing and capital expenditures have returned for good, both investors and the Fed will believe that the recovery has taken hold, and rates will undoubtedly be raised.

U.S. Factory Output Lags Far Behind 2003's Surge by Industrial Metals Prices
Year-over-year % change by quarter

Source: John Lonski, managing director and chief economist
at Moody's Investors Service.

Higher Industrial Metals Prices Hint of a Livelier World Economy

Source: John Lonski, managing director and chief economist
at Moody's Investors Service.

Soaring Industrial Metals Prices Imply Higher Fed Funds Rate by Spring 2004

Source: John Lonski, managing director and chief economist
at Moody's Investors Service.