Getting the
Fed Wrong Again
By Duru
April 12,
2005
Today's action
in the stock market gave us our surest sign this year that we are suffering
from a manic market. The Fed released the minutes from
the March 22, 2005 FOMC meeting, and the market soared after suffering the
kind of steady selling that often marks a climactic blast of negativity. My main man Mike comments
on the blow-by-blow, minute-minute action in the NASDAQ that clearly demonstrates
what happened. There are obviously
some speed readers out there because the instant the notes hit the streets,
some fast eyes concluded that the Fed had suddenly softened up again. They could not be more wrong.
First, let us
start with the premise that the Fed was on the verge of accelerating its
"measured pace" of rate hikes.
This was a rumor that was started because of one new hawkish sentence in
the official release the day of the meeting.
It caught on like wildfire because the market was already in a negative
mood and was ready to take the worst interpretation possible. I picked on this
reaction earlier. But now that I have
had a chance to read the minutes, it is clear that the Fed is not
about to accelerate the pace, but they sure have not ruled it out either! First, I am sure folks latched onto this
happy news:
"Although
the required amount of cumulative tightening may have increased, members noted
that an accelerated pace of policy tightening did not appear necessary at this
time, as a degree of economic slack apparently remained, productivity growth
would probably continue to damp increases in unit labor costs and prices, and
inflation would most likely continue to be contained. In these circumstances,
Committee members judged that the measured removal of policy accommodation was
appropriate for now."
OK. So, if you
are looking for an excuse to buy the sagging markets, this is all you need,
right? Wrong! Note that the Fed is suggesting that inflation is enough of a
concern that the final endpoint of
short-term interest rates has likely gone UP! UP I tell ya! The instant pop we saw in the markets should
be very short-lived once the true nature of this statement is absorbed. The Fed is doing its typical two-step tango
with words, but stay very still and quiet, and you will notice an admission
that they feel they may have earlier under-estimated the amount of tightening
they will need to do to ensure price stabilization. Perhaps we have received a stay of execution,
but an execution is coming nonetheless.
To make
matters worse, we find that the market's initial fears about potential
acceleration have some basis in reality.
It turns out there are members of the Fed who think that an acceleration
in rate hikes is a real possibility now…(and we should not be surprised by this
given the Fed's awe of the economy's strength, expectations of increased labor
demand, and cautionary stance about the potential return of pricing power in
some parts of the economy):
Members
also focused on the issue of whether to reiterate the judgment expressed in the
Committee's recent statements that ". . . policy accommodation can be
removed at a pace that is likely to be measured." Some expressed the view
that such language could constrain future policy inappropriately; while these
concerns were not new, they were now felt to be more pressing, as the odds that the Committee might need to
step up the pace of policy firming were thought to have increased. Members
noted, however, that the existing "measured pace" language was
clearly conditional on the economy evolving in a way that promised a gradual
return to high levels of resource utilization and on inflation remaining low,
and thus believed that the wording did
not rule out either picking up the pace of firming or pausing in the process of
removing policy accommodation should circumstances warrant. They also noted
that the language had not precluded a notable increase in medium- and
longer-term interest rates over the intermeeting period as markets extended the
expected gradual increase in policy rates. [emphasis
mine]
Man, oh,
man. Looks like I was a bit to
dismissive of the market's initial fears of the potential of an acceleration in
rate hikes. So, I find it ironic that
the market reads this stuff and now thinks that the odds of such an acceleration have seriously diminished. When I read this, I get stamps of
confirmation in 100 places all at once.
Most
importantly, the Fed makes it quite clear
that there are members who are beginning to ring the alarm bells over
inflation. The notes go into excellent
detail explaining the potential for an "inflation surprise" in the
economy. As these fears further infect
the Fed, we could see a sobering up of the markets that could make these past
few months look like a ride down a kiddie slide:
Still, many
participants indicated that their uncertainty about the intensity of inflation
pressures had risen in response to recent developments and that, in particular,
the distribution of possible inflation outcomes was now tilted a little to the
upside. Although monthly statistical releases could be quite volatile, the
recent data showing consumer inflation a little above previous expectations
were of concern. Also, anecdotal indications of price increases were becoming
more common across a number of industries. Some business executives reportedly
believed that, with aggregate demand expanding robustly and the lower foreign
exchange value of the dollar putting upward pressure on import prices, a degree
of "pricing power" had returned. Moreover, the recent rebound in spot
crude oil prices, and especially the substantial advance in prices of crude oil
futures contracts for delivery well into the future, suggested that a
significant unwinding of higher energy costs might not be in prospect. Several
participants indicated that, in current circumstances, they viewed an upside
surprise to inflation as potentially more harmful than an equivalent downside
surprise, partly because such an outcome could well impart additional upward
momentum to inflation expectations.
I fully
understand that today's reaction rally makes sense in light of the thick negativity
that has developed in the market now that complacency
has ceased. The buyers had to rush
in at some point. We may have even finally
started the
two-week rally I was anticipating to coincide with earnings season. But I
claim that the market, in all its well-meaning haste, has misread the true
import of the Fed's message to suit its current mood. I am not sure how long it will take for the
process of rationalization to unwind, but the next Fed meeting in early May
would make for an excellent tar pit. And
how can I be so negative? Well, if the
economy continues to show signs of robust strength, the Fed will be forced to
get even more stern in its new anti-inflation
stance. If the economy has slowed down
enough to dissipate inflation concerns, it will happen on the backs of
corporate profitability…and lower profits mean lower stock values. We are essentially on the edge of a no-win,
all-loss situation. The ultimate irony
in all this madness is that the Fed marches on a campaign to make their
thinking as transparent and well-anticipated as possible. For now, the market has proven to be too
manic to pay close enough attention. All
I can add to that is to entreat you to "be careful out there!"