The Fed's Not Done Being Done

By Dr. Duru written for One-Twenty

August 8, 2006


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Oh my....could it be? The Fed notes "economic growth has moderated" and "some inflation risks remain"? Don't worry. I won't holler stagflation - I will stick to my "slowing growth, persistent inflation" mantra.

The Fed finally gave the market the event that has caused the optimists to buy stocks intermittently for almost a year or so ...a pause in the interest rate hiking campaign. The beauty of the accompanying Fed statement is that it also contained something for the inflation hawks. Even though the Fed anticipates (hopes? prays?) that "...inflation pressures seem likely to moderate over time," they stand at the ready to increase rates again "...as implied by incoming information." In other words the Fed is done, but they are not "done done." And I strongly suspect they will be forced to hike rates at least one more time in the near future.

The most intriguing part of this story is that the Fed essentially had no choice but to pause. My youngest brother says they were "bullied" into it. Probably choice words! The market consensus had pause written in stone, the Fed futures said it, the bond market has been rallying for the past few weeks, sending 10-year rates lower and lower, alarmists have been whining louder and louder that the housing market is near collapse and ready to take out the entire economy (nevermind that compared to historical trends and norms, the housing sector remains quite strong. Of course, that means there remains plenty of room to fall...). Suddenly, folks are no longer worrying about inflation at all. The economy's desperate reliance on cheap money and high debt finally won the day today. Contrast this convergence against a hike in rates to the active and directed jawboning the Fed did back in May to pound the market into its current correction. What a difference, eh? Then again, "the Fed is done" hopefuls will remember Big Ben's well-received speech back on April 27, 2006 before he had to double-back and talk tough to defend the inflation-fighting honor of the Fed:

"The FOMC will continue to monitor the incoming data closely to assess the prospects for both growth and inflation. In particular, even if in the Committee's judgment the risks to its objectives are not entirely balanced, at some point in the future the Committee may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook. Of course, a decision to take no action at a particular meeting does not preclude actions at subsequent meetings, and the Committee will not hesitate to act when it determines that doing so is needed to foster the achievement of the Federal Reserve's mandated objectives."

That time has obviously come now.

So what's next? Given that the Fed had something for everybody, I suspect we will get more of the same kind of choppy, even range-bound, trading we have seen all summer. For example, we got the kind of post-Fed reaction that we typically get. Folks have been looking for a Fed pause to finally allow the market to roam free in one consistent direction, but the Fed gave us no resolution. The optimists will focus on the pause and extrapolate that the Fed is truly done. They will even happily anticipate the day when the Fed is forced to begin lowering rates to try to "save" the economy again (nevermind that American companies just reported something like their 16th straight quarter of double-digit profit growth!). Once the optimistis have exhausted their buying, the pessimists will have their way with the market selling as they foresee an economy grinding to a halt, and a Fed helpless to save the day as inflation risks persist (or worse yet, the Fed decides to inflate the risks by stoking growth). The optimists will then see a wonderful buying opportunity that may not come again....I think you get the picture!

I am keeping my eye on the Fall, on commodity prices, and on the economic data. Just today, the Labor Department provided more negative inflation news. It was the type of news that would have forced the market to sell off even harder than it did post-Fed announcement. Unit labor costs rose 4.2%, including a 5.4% rise in hourly compensation. This data point further supports the picture we got earlier of the rising costs to employ workers. Productivity increased 1.1%, so it was not enough to offset (or "justify" as some economists would put it) the higher labor costs. I also expect that with a pause in rates, speculators and buyers of commodities will get back into "show-me" mode and force the Fed to prove that it is serious about fighting inflation. Gold and silver bugs will encounter periodic disappointment whenever the market chooses to care about the potential for more rate hikes.

Regardless, forget what the pundits might tell you. The investing climate did not suddenly become more favorable. It is as uncertain as ever, and market trading will likely trend that way (meaning fading large moves will continue to happen over and over until some new, and sufficiently large, catalyst knocks us off-course). Since the beginning of the year, I have been holding my excitement until the Fed showed the "whites of its eyes." I see the whites now - but each eye is looking in a different direction!

Be careful out there!

DrDuru, 2006