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Wednesday June 9, 2004 - 13:28:31 GMT
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Greenspan Tightens Policy...Virtually by Foreign Exchange Analytics

Greenspan Tightens Policy...Virtually

One of my thoughts on what could take the dollar lower and bond prices for the next few months (above 1.30 and under 103) was the market turning on the Fed's, or more precisely the Fed Chairman's, virtual monetary policy where carefully worded statements not actual shifts in the Fed Funds rate prove an unconvincing response to rising inflation. Or put more simply, the market on balance viewing the Fed as behind the curve on inflation.

In a carefully worded statement read to a London audience via satellite, the Fed Chairman delivered his first significant message (virtual monetary policy tightening) in over two months. Sure we knew what the Fed's main thinking was on policy in as much as it was disclosed in the May FOMC meeting statement. But there were none of the typical Greenspan virtual monetary policy signals for the financial markets (and everyone else) that we have become so accustomed to and is in essence the way in which the Fed micro manages expectations and hence asset prices. Governor Kohn's remarks on Friday, arguably the only other policy signal from the Fed aside from Greenspan's speech Tuesday, fell well short of addressing the behind-the-curve camp (small and growing). Indeed Kohn was downright sanguine on inflation and seemed unflinchingly behind the measured-pace notion for tightening.

Greenspan too remained tethered to the measured-pace notion, but he also displayed a large pair of shears close at hand and capable of snipping this tether at a moments notice. In other words, if his low inflation assumption is proven wrong (has Washington been hit by a rare wave of self-doubt...Iraq policy, now Fed inflation assumptions?), out goes measured and in comes rapid (or at the very least not-so-measured pace of tightening). In other words those nervous Nellies out there on inflation need not worry any more. The Fed can fight inflation too we were reminded now that it vanquished deflation even though it never happened (deflation expectations anyway).

While I may not approve of Greenspan's unorthodox approach to monetary policy...virtual monetary is what it is and his remarks on Tuesday represent a tightening of policy however conditional. He bought and disclosed an option to tighten faster if need be. He was really saying that the back up in Treasury yields since the March jobs report in early April were justified and a further rise in yields is unjustified...the Fed has looked inflation in the eye and is confident inflation remains in a coma. And if it awakens from the coma the Fed has all the morphine it needs to keep inflation comatose.

Gee yields are higher (the curve steeper) unlike 1994 and the Fed has done nothing to raise rates from a 46-year low. The bond market is doing the work of the Fed. Virtual monetary policy at work...and working.

But the spell Greenspan has over the markets could be broken. Virtual monetary policy will not work if the spell is broken. How can this spell be broken? By exclusively talking the talk but not walking the walk. At the end of the day the Fed needs to hike rates (really at the start of the in May). A quarter point hike in Fed Funds June 30 is baby step on the inflation fight. Central bankers are "independent" for a reason. They are paid to err on the side of restraint. They are rewarded for moving early to check inflation. This Fed is all about supporting growth. Even when inflation is dancing around the recovery room well out of the coma. Every inflation measure is rising, and most worrisome are the core measures. Anyone who does not earn enough money to notice sees higher milk prices, higher cereal prices, higher meat prices, higher local taxes, higher restaurant prices, higher airline ticket prices, higher education expenses (even at public schools where extracurricular activities are now highly subsidized), higher insurance costs, higher borrowing costs (no thanks to any real monetary action) and higher energy costs. These are not events exclusive to the New York metropolitan area. They are as evident in Buffalo as in Manhattan.

Greenspan has a damned good record on growth and inflation. So breaking the spell he holds over markets is not easy. But it is more at risk today than any other time since his early days as Fed Chairman (1987). Tuesday proved he can talk the talk when it comes to inflation, but everything else shows he is reluctant to walk the walk. Moving 25 bps June30 will show he can step the step not walk the walk. He is already behind the curve by not going in May and demonstrating his reluctance to recognize that inflation is heading for the hospital exit doors. And if anything it is the bond market that is in the hospital bed on the drip feed. Any discounting of the Greenspan premium ahead, behind a slow response in real monetary policy to a real rise in inflation, will mean a lower dollar and higher yields (steeper curve). I am betting on markets awakening from the coma and questioning the wisdom of virtual monetary policy.

David Gilmore


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