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The Fed's Just Getting Warmed Up

Analysts say the Fed is now on track to reverse its three rate cuts made in 1998.

This might end up being more trouble than it's worth.



did one thing that everyone expected -- it raised the fed funds target rate 25 basis points to 5%. But the accompanying

statement confused a good number of people, saying the Fed has, for the time being, shifted back to a neutral directive. The stock market seized on this and took off, which might be the last thing the Fed wanted to see. The September fed funds contract, which trades on the expectation of changes in policy, today is only discounting a 52% chance of another rate hike by September, compared with 80% yesterday.

So are they done? Bollocks. In fact, three sources interviewed said today's shift to neutrality in no way decreases the possibility of more interest-rate hikes, and all three believe the Fed is on track to reverse the three 1998 interest-rate reductions taken in response to the global economic crisis.

"I don't think they feel guilty about tightening with no inflation until they take back the three from last year, and right now I'd put better than 50% odds on an August tightening," said Russ Sheldon, chief economist at

MCM Moneywatch


Sources believe the Fed shifted back into neutral because the bias had generally been used to signal that the Fed was considering an intermeeting move. And today's statement is as close to a tightening bias as one can get, with phrases like "the Committee ... must be especially alert to the emergence or potential emergence of inflationary forces that could undermine economic growth." But it's also provided the Fed a ready-made reason to consider more rate hikes, because a prolonged rally in the financial markets could negate the effect of the rate hike.

"I think what they said today is they'll sit on their hands a little longer," said Barbara Kenworthy, head of fixed income at

Prudential Investments

. "The caveat is if the stock market continues to rocket. That causes more concerns about spending because it could reprime the pump -- we're finally starting to see some slowdown in housing and consumer spending."

Which Way Did They Go?

The market was fully anticipating the Fed to retain the bias toward raising rates. But the markets are still forced to struggle with how much weight to put on wage-related and price-related inflation reports. Obviously, a significant rise in that data, such as the

Employment Cost Index

and the

Consumer Price Index

, will provoke a response from the Fed, but stable prices don't automatically negate the possibility of still-higher interest rates.

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But at this point, inflation hasn't emerged -- something Fed Chairman

Alan Greenspan

admitted on June 17 in response to a question before the

Congressional Joint Economic Committee

. But both Greenspan's specific explanation of last year's emergency rate cuts, and officials' public comments during the last two months indicate they're worried that demand will eventually result in wage or price inflation.

A rallying stock market will only enhance demand, and Kenworthy's going to be watching the consumer spending and housing figures over the next few months. She believes that, if today's action by the Fed engenders lower interest rates and higher asset prices, spending will shift back into overdrive -- and the Fed will use that as evidence that more rate hikes are necessary to fend off wage inflation.

"If you continue to get strong growth, you'd have to think the Federal Reserve would tighten monetary policy," said William Quan, economist at

Aubrey G. Lanston

. "Inflation is looked at as a lagging indicator. If we get a pickup in inflation indicators, the market's interpretation might be that it's too late."

Is it already happening? The Fed's

Beige Book

, its anecdotal survey of economic activity, said earlier this month that producers across the country were reporting wage pressures. And Greenspan told the JEC that "despite its extraordinary acceleration, labor productivity has not grown fast enough to accommodate the increased demand for labor induced by the exceptional strength in demand for goods and services."

Greenspan said in his

remarks June 17 that a 3% rate of growth is what's currently sustainable in this economic environment, and the approximate 4% rate this country has been running at during the last three years is a result of a continually diminishing labor pool. The Fed's worry that this will lead to wage pressures is the foundation for why it'll continue to be pre-emptive, Quan said.

It Just Doesn't Matter

There's also a bit of a fatalistic sense among those in the market that the Fed will do whatever it takes to remove at least 50 basis points, if not all, of the emergency easings undertaken last year. Today's statement again refers specifically to those actions, saying the "full degree of adjustment is judged no longer necessary." It may be that they believe "some degree" of adjustment is still necessary, perhaps not all, but Sheldon said that part of the statement is almost worthless. "They're models of obscurity," he said. "The idea is to not box themselves in."

If inflation pressures do creep into the market, they're going to raise rates, obviously. If demand continues to run at this pace, the Fed is going to continue to worry about inflation -- possibly until it's taken back the 75 basis points it gave the market last year. Only a pronounced slowdown in demand might be enough to stave the Fed off, but that's not a sure bet either. "I think it's going to take another couple steps," said Sheldon. "Beyond that it's a little tougher for them -- then they're really fighting growth rather than inflation."

It is curious that Greenspan attempted to justify, in two specific references, the purpose of the 75 basis points in his comments before the JEC. He said those moves were necessary in that global economic environment. Today, most in the market would admit that the global markets are showing some semblance of recovery.

"Those three cuts were geared toward global liquidity, rather than economic conditions," said Kenworthy. "You could almost make the point that two more moves would not be hugely pre-emptive, but would be getting back to where the Fed was before the easing."