Commentary: The Fed’s Big Turnaround
loomberg News
NEW YORK — The financial markets have a complex, convoluted and constantly changing relationship with the Federal Reserve, the institution wielding power over short-term rates.
Sometimes the Fed is a guardian angel, watching over the market in times of stress. Following Russia’s default and the near-collapse of hedge fund Long-Term Capital Management in the summer and fall of 1998, the Fed dispensed 75 basis points of interest-rate medicine to re-liquefy a desiccated financial system.
The Fed can be downright seductive when it wants to be, whispering sweet nothings in the market’s ear, keeping it in a state of excitement, withholding ultimate pleasure until a time of its choosing.
The Fed is viewed alternatively as all-knowing, all-seeing (better access, better data, better econometric models) and totally irrelevant. Never has an institution commanded so much attention from so many people for such an extended period of time when the one thing the central bank does — set overnight interbank rates — is viewed as irrelevant!
The perception that the Fed is omniscient should be reevaluated in light of the events of [Dec.19], when the Fed did an about-face. No longer are policy makers worried about inflation risks, which were the paramount concern six short weeks ago. Now the Fed thinks the greater risk is weighted toward “conditions that may generate economic weakness in the foreseeable future.’’
Surely this is one of the fastest turnarounds in the annals of Fed history. In fact, Fed Chairman Alan Greenspan signaled the shift at a Dec. 5 speech, less than three weeks after the Nov. 15 meeting at which policy-makers thought inflation was the greater threat.
One year ago, in an effort to remove “unanticipated confusion,” the Fed abandoned its policy of issuing a directive following each meeting — an indication of policy-maker’s near-term leaning — in favor of a statement describing its assessment of long-term developments. The Fed hoped to distance itself from an inter-meeting commitment on interest rates and instead convey the spirit of its thinking.
Already the fissures in the new policy are apparent. Short-term trends affect long-term thinking. Open the doors of the Temple, and its inner workings seem a lot less holy.
The economic data have deteriorated so rapidly across all sectors of the economy —consumer spending, consumer sentiment, investment spending, manufacturing, and even a warning about housing — that the Fed went from port to starboard without pausing at mid-ship.
Many economists were disappointed that the Fed said it felt the economy’s pain but wasn’t willing to alleviate it. ING Barings Chief Economist Larry Kudlow called it a “bonehead decision.”
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Bear Stearns & Co. economists were surprised that given the long list of “ailments’’ cited by the Fed — a drag on demand and profits from rising energy costs, eroding consumer confidence, shortfalls in sales and earnings, and financial market stress — “the doctor didn’t administer some treatment.”
The doctor may have to pay a house call before the entire medical staff meets again on Jan. 30-31. In saying that “the Committee will continue to monitor closely the evolving economic situation,” the Fed left its options more open than normal, says Susan Hering, senior U.S. economist at UBS Warburg. It put the market on warning that the Fed is more serious about how weak the economy is,” she said.
Hering and other economists think the Fed may lower rates before the next meeting. Alternatively, policy-makers could slash the funds rate by 50 basis points in late January to bring it more in line with market rates.
Yields on Treasury securities, from bills to bonds, are already well below the 6.5% federal funds rate, which analysts and traders view as a sign the Fed is behind the curve.
Where are all the folks who think the market can do the Fed’s work? When the Fed is raising interest rates, as it did from June 1999 through May 2000, economists and traders talk glibly about the market doing the Fed’s work. Specifically, the market pushes up long-term interest rates so the Fed has less heavy lifting to do on its own, the thinking goes.
Is it a one-way street? Does the market only do the Fed’s work when rates are rising, not falling?
Of course, this view alternates with the idea that interest rates don’t matter one whit, that technology is immune to higher interest rates, which will be remembered as one of the great myths of the late 1990s tech bubble.
The Federal Reserve is sure all things to all people. Or does it just fool some of the people some of the time?
