Getting the Fed Wrong Again
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!"