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Wednesday June 30, 2004 - 01:39:36 GMT
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Fed Knowns And Unknowns

Fed Knowns And Unknowns

Borrowing from the US Secretary of Defense line of reasoning when it comes to the Fed there are knowns, known unknowns and just plain unknowns ahead of Wednesday's FOMC rate decision and statement.

The knowns are the 25 basis point rate hike the Fed has telegraphed to the markets more clearly than any other rate decision in its history. And the Fed has also made it clear (another known) that based on its current assumptions on inflation and growth, the Fed believes that policy accommodation can be removed at a pace that is likely to be measured, as the May04 FOMC statement concluded. Indeed it is unlikely the statement alters the balance of risks assessment much. on May04 it said upside and downside risks to achieving sustainable growth are roughly equal and the risks to price stability have moved into balance (probably will be changed to are in balance).

So what are the known unknowns? Whether Greenspan thinks there is enough intrameeting evidence on inflation, jobs growth, unit labor costs, productivity growth and GDP to recognize the balance of risks on the price stability goal are now tipped toward inflation and or risks to sustainable growth goal are tipped in favor of overheating are two known unknowns. Surely any such shift in the assessment of risk would necessitate a change in the key sentence on the pace or plan of tightening.

I think Greenspan is not overly bothered by recent data to warrant ratcheting up its intentions on lifting the fed funds rate and hence "measured pace" stays, and the balance of risks assessment also stays the same. Greenspan is comfortable with what the market is pricing in on rates and he is also put the markets on alert that everything now assumed by the Fed on the pace and scale of tightening can change at a moments notice. If the Fed finds the data or market expectations demand more rapid and larger rate hikes, it will do so with swift efficiency. In other words any changes ahead will reflect new data that demand a more aggressive removal of accommodation.

And it should be noted that since Greenspan's Senate Banking, Housing and Urban Affairs Committee confirmation hearing on June15, there is nothing in the data to justify any new message in Wednesday's FOMC statement...including the upward revision in core PCE price index in the final revision of US 1Q GDP last week. Could the new statement drafted by Greenspan (he writes all of them according to former Governor Meyer and it has only been in the last few years that the draft statement is handed out ahead of FOMC meetings so members can be better prepared to discuss it) add conditionality? In other words add a phrase noting what Greenspan told the Senate hearing...if the Fed assumption is wrong on inflation (rise is temporary, adequate slack in labor and product markets to check wage and price pressures, including fat corporate profits), it will adjust its tightening pace. If it does no big deal (for dollar and asset prices). It is part of the public record regardless. It would be far more significant if Greenspan changes the assessment of risks which would at the very least change the meaning of measured pace, but very likely see this phrasing changed if not all together abandoned. Again this is not likely.

The short end of the curve is correct to put a half point hike in play for the August10 FOMC (now seen as a 30% chance). By the August10 meeting the Fed will have in its hands June CPI, June payrolls (out this Friday) and July payrolls. Strong releases will elevate the risk of 50. And there is inflation expectations...the Fed could be drawn into 50 basis points in August if the Treasury market took yields higher behind upcoming data and concludes the Fed is behind the curve.

And the end game for the Fed is a neutral fed funds consensus on how to measure, but essentially it is in the neighborhood of 300-400 basis points away from today's 1.00% 46-year low in funds (assuming the rate of inflation does not rise much). That is a long way away with a measured pace, especially if the election in November and the rising risk of a terrorist attack keep the Fed on a path of baby steps. And there is the unstated (known) concern that moving too quickly could choke off the recovery just as it is gaining momentum (the BoJ's legacy). Rapid increases in the funds rate might disrupt the credit market, still exposed to rising rates from this extraordinary period of low rates (official and otherwise). Real estate prices (household wealth), credit derivatives and GSE debt could all face undesirable consequences from an overzealous Fed. Indeed it is these risks and the experience of 1994's tightening cycle (and undesired fallout) that has Greenspan and the Fed stressing transparency. It wants to limit uncertainty to the data, the one thing it can't control.

Greenspan is also facing the legacy issue. Leaving the Fed by 2006 with a return of inflation (north of 5%) or with growth negative to 2% SAAR would not be optimal for how the Chairman is treated by history. So it followsfrom where the economy is currently and where it has come from in the last year, the Chairman is seemingly willing to err on the side of accommodation. That said not even this Greenspan critic thinks the Maestro is not first and foremost driven by what is best for the economy and down the line what is best for his legacy.

What would I have done differently with the benefit of hindsight (no I am no Greenspan, just a mortal)? Stopped easing in the 1.50-2.00% area last year and hiked 25 basis points on May04.

David Gilmore


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