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Wednesday May 5, 2004 - 18:17:53 GMT
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Greenspan's Siesta On Fed Funds

Greenspan's Siesta On Fed Funds (FXA)

On Tuesday I made the case for why the Fed should hike rates. I also said the Fed would not hike rates. Not as long as Senor Greenspan is calling the shots.

What did Tuesday's FOMC statement and inaction on rates say about the Fed and rates that is not obvious to the more than casual observer of the US central bank? Unfortunately, or fortunately, not much. The first point is the Fed and Greenspan feel perfectly comfortable with a 1.00% Fed funds rate even with inflation measures uniformly rising, employment growing and market rates rising. The statement also made it perfectly clear that the Fed will fire the first shot on rates when it is is neither patient not impatient. In this regard a jump in US April non-farm payrolls onFriday could put a June30 rate hike right on the front burner, and we doubt the Fed would try and talk the markets out of expecting a June hike. Conversely, a weak payroll number Friday would not only get the market to rule out a rate hike June30, but it would put an August10 rate hike in jeopardy. In other words the Fed and Greenspan in particular have the desired flexibility to raise rates or not to raise rates. Furthermore the markets have been put on alert. So when the Fed decides it is time to hike, no one should be surprised.

But isn't the Fed getting further behind the curve by not moving sooner than later? This crowd remembers the 1994 tightening cycle when the Fed went at rate hikes with reckless abandon taking rates up 275 basis points over 13 months before Fed funds peaked at 6.00%. And the cycle included one hike of 75 basis points. The Fed for its part has made it clear to insiders and the public at large that this is no 1994 all over again. One major difference is in 1994 the Fed was not using the written and spoken world as tools of monetary policy in any formal way to the extent it is today (call it transparency, though this is a Fed term, or perhaps controlled and deliberate manipulation).

And the Fed has a litany of reasons why the return of inflation is unlike any previous business cycle upturn...hence the gradualism, and hence ruling out 1994 deja vu. Slack in the labor market, excess capacity in manufacturing, high productivity, and increasingly rising energy prices, especially gasoline. Energy demand in the short- to medium-term is relatively inelastic and corporate profits and household disposable income takes a hit.

Fine. Makes sense. Wait a minute. Well it would make more sense if Fed funds were running at ECB level of 2.00% or even higher. But at 1.00%, the argument that the Fed is behind the curve is strong. And it was the Fed Chairman who in 2003 assured the last couple of rate hikes were insurance against deflation. Since declaring the end of deflation does it not make sense to remove this insurance? So far markets have largely given the Fed and Greenspan the benefit of the doubt on timeliness of tightening and level of the nominal (and real) Fed Funds rate. This blind faith could be challenged in upcoming data like payrolls and inflation reports for April and May, all of which will be in the hands of the FOMC by the time of its next meeting on June30. And if the data looks strong and suggests the Fed may be behind the curve, Greenspan and his compadres can verbally tighten ahead of the June30 meeting.

Something is missing in from the analysis. Something else is bothering the Fed and preventing even the modest of policy normalization steps. Perhaps Canada's Finance Minister Goodale hinted at it today when he said that at the G7 meeting officials were acknowledging the return of inflation and the inevitability of rising interest rates. Remember G7 central banks heads including Greenspan were at this meeting and presumably led this discussion. Goodale said "I think there was a desire around the (G7) table to make sure that as we face the prospect of increasing interest rates at some point in the future - obviously not immediately...- that it is managed in a way that is not disruptive." He added "Everyone needs to pay attention to the nature of debt portfolio that exists." And he added "A time of low interest rates is not a time to get careless and sloppy." Did Goodale come up with this on his own or was he parroting Greenspan? Sounds like the Fed and presumably G7 is really on tenterhooks on rates because it is worried about a credit market bubble and the distortionary effects on asset prices and allocation of capital in an extended period of extraordinarily low rates. Surely Greenspan would never be this explicit, even in the confessional booth of G7 (especially at G7).

David Gilmore


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