Tuesday November 1, 2005 - 21:45:00 GMT
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FOMC Stays Course
Bill Gross can say the Fed is just about done on tightening until he is blue in the face. Greenspan and Bernanke are not listening. Gross is not wrong to question the sustainability of the current expansion given the weak foundation it is built upon. But until the foundation buckles, Gross would do himself well to listen to the Fed. First the Fed is confident growth will continue at a healthy clip (above 3%) despite energy hitting demand and investment, and despite hurricanes Katrina and Rita. But there is something in the statement for even Gross to cheer...inflation is seen as pretty benign at the core level and inflation expectations equally benign. The Fed does not seem keen on altering these observations and or assumptions, even if the yield curve is unusually flat for this stage of the tightening and business cycle.
The statement could have been more hawkish on inflation I think. Productivity growth is slowing, oil prices are off peaks but stubbornly high by historical comparisons, the economy grew at 3.8% SAAR in Q3 despite Katrina and Rita and corporations will need to lift prices to defend profit margins sooner than later. Indeed the Fed will have to make a convincing case (probably left to Bernanke), that pausing at neutral Fed funds rate is appropriate when price stability is far from assured. I don't know about Gross, but in my world of Macro 101, periods of inflation imply restrictive, not neutral policy mandates. The Fed ahead, assuming the economy does not get derailed, will be forced to introduce restrictive monetary policy or risk losing a battle if not the war on inflation at some later date. Unless the US housing market corrects or long-term interest rates rise more rapidly than short-term rates, the Fed's march to neutrality will turn into a march to restraint. I can count 3 more rate hikes without a lot of hand wringing...Dec, Jan and Mar...two more by Greenspan (the person) and one by the Bernanke-Fed (institution). And if the wheels stay on the economy, and restraint is embraced by Bernanke, then we can look for 5.00-5.50% Fed funds rate in relatively short order in 2006.
If the Fed goes from neutral to restraint in 1H 2006, it is not a market where bonds or stocks will do well. The dollar may well press higher as investors play the carry trade over the structural trade. But the higher the dollar goes the harder it falls. I think the wheels will come off...inevitable...the Fed is forced to keep tightening in an environment where imbalances worsen raising the chance of a disorderly adjustment (I could be taking this straight from the Bank of Canada, OPEC or the IMF). But like Greenspan on neutral Fed funds...won't know it until he sees it....won't know about the wheels coming off until they do. Until then, it is onward and upward for Fed funds.
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