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Walking the Fed Tightrope

Today's move to a tightening bias has unnerved investors just a bit.

Citing a potential buildup in inflationary pressures, the Federal Open Market Committee this afternoon adopted a bias toward tightening even as it left the fed funds equilibrium rate unchanged at 4.75%.

In and of itself, the tightening bias means very little. After all, for a good part of last year the

Federal Reserve

had a tightening bias, but then eased interest rates three times toward the end of the year.

Stocks gave up modest midafternoon gains on the news, swinging into the red. The bond market, which was up for most of the session, slipped from its intraday highs, giving back the bulk of today's gains. The dollar appeared to strengthen slightly on the news.

The focus now shifts to the next FOMC meeting, scheduled for June 30. Using the July fed funds futures contract as the closest proxy for expectations for that meeting, the market has discounted about two-thirds of a 25-basis-point rate hike at that time. The September fed funds futures contract, more thinly traded, has already priced in 20 basis points of a potential 25-basis-point rate hike.

Going forward, the market will closely monitor price pressures in the product markets as seen in the producer and consumer price indices. However, these are largely historical indicators and following them has often been compared to driving by looking at the rearview mirror.

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Measures of labor-market tightness and the shape of the U.S. yield curve may be more instructive, if for no other reason than the Fed is believed to pay close attention to such indicators. A steepening of the U.S. yield curve, i.e., the difference between short-term and long-term interest rates, may be used to gauge anticipated inflation pressures, and where the Fed is perceived to be relative to the inflation curve.

There are a couple of things to keep in mind when contemplating the outlook for Fed policy. First, as the year progresses the Fed's room to maneuver may be increasingly limited by the Y2K problem. Using the December eurodollar futures contract as a proxy, the market has already priced in the likelihood that the turn of the millennium is likely to produce a spike in interest rates.

The Federal Reserve, well aware of this, is unlikely to do anything to exacerbate this pressure and related uncertainty. This is yet another reason to look for a move earlier rather than later. Second, the market continues to anticipate that the possible Fed tightening is a one-off measure, not necessarily the beginning of a series of moves.

Third, some argue that the markets have done the Fed's tightening for it. To some extent this is true. Nevertheless, the Fed needs to ratify or validate the move. And it seems unreasonable to expect the Fed to take the better part of the summer to do so. In the coming weeks, look for the July fed funds contract to discount the entire move. As is the market's wont, an overshoot is likely, not so much in the fed funds futures contract, but in instruments whose anchors to overnight rates are more elastic, like the two-year note and eurodollar futures.

Finally, a one-off move need not derail the bull market in equities. The traditional rule of thumb is that it takes more than one move to prompt a significant revaluation of equity prices. That said, the historic high valuations, of course, may leave the market a bit more vulnerable than the traditional rules of thumb would suggest.

Marc Chandler is an independent global markets strategist who writes daily for 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