Why the Fed Will Stand Pat

Don't expect the Fed to ease on Tuesday, but the markets do believe the odds shift back to an ease in February.
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Federal Reserve Open Market Committee

(FOMC) meets on Tuesday for the last time of the year. After cutting interest rates three times between late September and mid-November, look for the Fed to "watchfully wait" and stand pat.

Fear of a looming credit crunch, which drove the earlier rate cuts, has subsided. The financial markets continue to normalize. Many credit-risk spreads have narrowed and will continue to do so. The market for new issues has resumed, and there has been a notable increase in bank lending to fill in the vacuum created by the short-lived paralysis of the capital markets.

A Surprising Strength

The economy continues to befuddle most economists. The economy is more robust than many, including the Fed, had anticipated. Real sector data, outside the manufacturing sector, have generally been reported above consensus forecasts. The external sector remains a drag on growth, but in recent months, the market has more often than not exaggerated that drag.

The strong October and November retail sales reports suggest that real spending is expanding at around a 5% annual rate. That means the U.S. economy is likely to grow between 3% to 4% in the fourth quarter and is enjoying good momentum as the year winds down. Many observers do not appear to place sufficient emphasis on that momentum.

The housing sector also is strong. Lead indicators like buyer and seller traffic are near record levels. The weakness in housing starts, reported for November as down 2.7% at an annualized rate, appears largely concentrated in the volatile multifamily-dwelling category -- apartment buildings -- where some excesses are being worked off. Single family starts rose by 5.0%

At the same time that economic activity has been consistently stronger than expected, measures of prices have generally been reported below expectations. Consumer prices have risen by 1.5% over the past year. This compares favorably with the 1.7% inflation rate for all of last year.

Reading the Tea Leaves, Day by Day

A close look at the Federal Reserve's recent operational policy also suggests it will not cut rates Tuesday. Unlike when I

anticipated the Fed's mid-November move, the Federal Reserve has not been providing reserves as generously to the banking system.

Earlier this fall, the Federal Reserve's open-market operations often succeeded in driving the effective fed funds rate below the equilibrium target level. This is not the case in recent weeks. In fact, a quick calculation reveals that the fed funds rate has been averaging above the 4.75% target for the first half of the month. While seasonal pressures may indeed be at play, the Federal Reserve, if it so chose, could do more to offset them.

Two other measures of the Federal Reserve's operational stance supports this point. First, the

Federal Reserve of St. Louis

tracks what it calls the adjusted monetary base. Its growth rate has stabilized in recent weeks. Second, the free reserves in the banking system, which is excess reserves minus discount-window borrowings, have also stabilized. Fed watchers often use free reserves as a down-and-dirty way of monitoring the monetary stance.

It will not be a surprise for the market if the FOMC leaves rates unchanged. The December and January fed funds futures contracts imply an average effective fed funds rate above the 4.75% target. However, the markets believe the odds shift back in favor of an ease at the February FOMC meeting. The yield of the Eurodollar futures strip is consistent with this view, and that easing has been priced in all the way through the first quarter of 2000.

On the other hand, an easing by the FOMC Tuesday would potentially prompt a strong market reaction. Not only because the move would catch most market participants by surprise, but it would also trigger concern that the Federal Reserve is aware of some problem that the market is not. Credit-risk spreads would likely widen rather than narrow. In addition, if the fed funds rate cut were not coupled with a discount-rate cut, then both key rates would be at the same 4.50%. Symbolically, it would signal an open-spigot monetary policy, something the Fed may be loath to do with the economy continuing to grow above trend.

The Consumer Remains King

The composition of U.S. growth has shifted. Since 1995, the U.S. economy appeared to stand on three legs: capital spending, foreign trade and housing. The first two legs have weakened in recent quarters. The sharpest deterioration of the U.S. trade balance may be behind us if world growth prospects improve, especially in Asia after a horrific 18 months. Meanwhile, the third leg remains in place, helped by the low interest-rate environment

The consumer has stepped in to fill the gap left by weakening capital spending. Household income, in inflation-adjusted, after-tax terms, is rising at an approximately 3% annualized pace. While this is a healthy clip, it may actually understate the case. Wages and salaries, which account for almost two-thirds of household income, are rising at nearly 6%. The remaining third, which reflects interest income, unemployment benefits and income transfers, is subdued for both cyclical and structural reasons. Continuing low inflation also strengthens consumers' purchasing power.

While the U.S. savings rate is low, talk of a negative number is disingenuous. It is a statistical fluke. First, because of favorable rates of return, American savers are more efficient than many of their overseas counterparts. Second, if capital gains are included, American savings are distinctly positive. This is important because Americans hold a greater share of their savings in financial assets than do savers abroad.

The good news is that the storm clouds


spoke of have not rained out the U.S. economic parade. The bad news is that the storm clouds remain on the horizon and may still come ashore. Asia has not returned to the path of sustainable growth, and many challenges in Latin America have yet to be addressed. The impact of weak commodity prices, including oil, is likely to exacerbate many developing countries' problems. Meanwhile, U.S. corporate profit margins may get squeezed further. Look for the Fed to respond to even the slightest signs of economic or financial woe, for on its shoulders rest not only the U.S. economy, but also, arguably, the world's.

Marc Chandler is an independent global markets strategist whose column appears Mondays and Thursdays. At the time of publication, he held no positions in the instruments discussed in this column. While he cannot provide investment advice or recommendations, he invites you to comment on his column by sending a letter to him at mchandler@erols.com