January 29, 2004

A Word's As Good as a Hike

The Fed has spoken, but nothing has changed. There's only one line in the Fed's short statement from yesterday that matters. Here it is: "With inflation quite low and resource use slack, the Committee believes that it can be patient in removing its policy accommodation. " This last line was different from the FOMC's December 9th statement that read: "However, with inflation quite low and resource use slack, the Committee believes that policy accommodation can be maintained for a considerable period." The market took this to mean that the Fed has moved away from its long-term accommodative stance, and opened the door to raising rates as early as this year, IF the economy heats up and inflation in consumer prices makes an appearance. Stocks fell. Bonds fell. Gold was up. And so was the dollar. But nothing has really changed. The Fed sees no inflation in consumer prices. The labor market is sluggish. Home sales were down 5% in December. The Mortgage Bankers Association reported that its weekly measure of mortgage activity fell by 5.2% last week as mortgage rates crept back up. Taken altogether, there's no macro case for raising rates any time soon. In fact, the only good explanation for the policy change is that the Fed wants to support the dollar in words without actually changing its monetary policy at all. This would be a relief to the Europeans and the Japanese, and might reduce trader's expectations for something momentous to come out of the upcoming G-8 meeting. If the dollar is stronger going into the meeting, the urgency to DO SOMETHING about a weak dollar is diminished. And of course, all this is accomplished, as I said, without making any change at all to the cheap money policy. So what's the immediate forecast for stocks, bonds, and the dollar, based on the Fed's new language? Stocks are still pricey. And the more lukewarm the eco news, the lower they could go. Bonds were spooked by the Fed's language. But in my view, the Fed's resolve to actually raise rates (much less a pretext for doing so) is sorely lacking. As stocks weaken, bond prices will go back up. And you may even see yields fall back below 4%. As for the dollar, a lot depends on how much pain its decline is causing foreign investors who own U.S. stocks...and foreign exporters. But even more depends on the fact that the U.S. government has no plans to reduce its deficit in the near future. And the current account deficit shows no signs of improvement either. The dollar is weak and getting weaker because the U.S. twin-deficits are large and getting larger. This is the fundamental tension in the currency markets that cannot be avoided. The dollar is weak because it deserves to be weak. And unless the Fed really truly means to raise rates to strengthen the dollar (something the Fed won't do until the labor market, or inflation picks up), the dollar is going to fall, no matter how "patient" the Fed is. If you're hunting for yield, Australia and the U.K. are two great places to find it. Interest rates are higher than, and may go even higher in the short-term.


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