Slow down Mr. Chairman


This week the Federal Reserve Open Market Committee met and raised the Fed Funds rate another 25 basis points to 3.5%. This is the tenth consecutive increase since June of 2004 when the rate was at a 50 year low. The Fed Funds rate is the interest rate at which banks lend to each other overnight and as the U.S. short—term benchmark. It is enormously important because it influences market interest rates throughout the world.

Bond market mavens all over the world watch this decision with baited breath, not only to gauge the actions of the Fed but also to analyze in excruciating detail the FOMC statement that accompanies the action by the committee.  Even though the FOMC has raised the rate ten times over the past 14 months the most recent statement would seem to indicate that they are not finished.

The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Aggregate spending, despite high energy prices, appears to have strengthened since late winter, and labor market conditions continue to improve gradually. Core inflation has been relatively low in recent months and longer—term inflation expectations remain well contained, but pressures on inflation have stayed elevated

The operative words in the statement are "accommodative" and "pressures."

Chairman Greenspan and company apparently believe that inflation continues to be more of a problem than a potential economic slowdown. There is a growing chorus as well as some evidence that disagrees with the FOMC action and is raising concerns that they may tighten too aggressively and send the economy into recession. In a recent Wall Street Journal online poll 54% of the economist included expressed this concern

The thin spread between the five year yield at 4.13% and the old thirty year bond at 4.47% would make it appear as though the bond market is much less concerned about inflationary pressures than Greenspan and the Open Market Committee. Which is more likely to be the result of enormous increases in energy prices, higher inflation or an economic slowdown? Even though energy prices add pricing pressure to almost all products, the slowdown  could be brought on by the diversion of discretionary spending money from consumer product consumption to the consumer's gas tank and home heating oil burner.

History has shown that inversion of the yield curve has preceded the last five U.S. recessions. The yield curve inverts when Fed driven short term rates exceed longer market driven rates. The yield curve may forecast the turning points of the business cycle.  If long term rates continue at these levels and the Fed insists on continued hikes an inversion of the curve is almost a certainty.
A most recent example of this is in the year 2000 when the Fed continued to raise rates to the point of inversion as a defense against inflation brought on by the supposed "wealth effect."  Failing to anticipate the impending recession they then had to scramble with numerous rate reductions to little to late as a defense against the recession.

Chairman Greenspan is soon to retire it would be a shame if his lasting legacy was that he pushed the country into recession on his way out the door.

Phil Gallagher   8 13 05