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The Fed shows its dovish side

The Federal Reserve finally took a break from its two-year rate-hike cycle on Aug. 8.  But as usual, the devil was in the details of the post-meeting statement, which parsed the move as a pause rather than necessarily marking a peak or turn in the cycle.
/ Source: BusinessWeek Online

The Federal Reserve finally took a vacation from its two-year rate-hike cycle at its Aug. 8 policy meeting. Board members voted to leave the benchmark Fed funds target rate at 5.25% after a busy two-year tightening cycle, which began at the June, 2004, meeting. Then, the Fed funds rate sat at a mere 1 percent—a five-decade low.

Policymakers held rates steady while patting themselves on the back for a job well done and keeping the pretense that there may be more work to be done down the road if inflation does not retreat as expected. Richmond Fed President Jeffrey M. Lacker dissented in favor of a quarter-point hike— slightly marring the image of the new consensual Bernanke era and implying a more vigorous debate behind the decision than might be apparent.

Changes from June
As usual, the devil was in the details of the post-meeting statement, which parsed the move as a pause rather than necessarily marking a peak or turn in the cycle. The communiqué was a pared-down version of the June statement but with a couple of notable alterations. Vindicated by recent data, the Fed maintained its belief that economic moderation remained central to its policy stance due to the combined impact of the cooling housing sector, firm energy prices, and lagging impact from past policy tightening.

The slowdown in second-quarter gross domestic product growth to 2.5 percent and subpar 113,000 gain in nonfarm July payrolls for July provided the needed cover for the Fed's new position. However persistent firm core-inflation readings, core personal consumption expenditure price gains, slackening productivity growth, and near doubling of unit labor costs to 4.2 percent in the second quarter will likely keep the Fed vigilant.

The central bank's views on inflation risks were refined somewhat compared to the June statement, though it still acknowledged firm core-inflation readings. It also stated that "the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures"—though these are likely to "moderate over time." This last reference to "moderate over time" replaced "limit inflation pressures over time" from June and therefore proved slightly more dovish as well.

Calm reaction
Yet the Fed dropped its reference to productivity gains being helpful in keeping down unit-labor costs. The Aug. 8 release of worse than expected productivity data proved that claim was no longer tenable. The absent phrase read: "Ongoing productivity gains have held down the rise in unit labor costs." However, in the Aug. 8 statement the Fed expanded the remaining view on "contained" inflation expectations and cumulative effects of monetary actions as likely to moderate inflation pressures over time, as noted above.

Considering the pivotal nature of the Fed's decision to take a holiday from tightening, the markets reacted fairly calmly after discounting and perhaps influencing the event in advance. The dollar initially retreated but found its footing again as long yields rebounded, while equities quickly gave up early relief gains and finished lower.

Fed funds futures, a trading vehicle for market pros to bet on future interest-rate moves, rallied along with sharp gains in shorter-dated Treasury issues. Futures suggest minimal risk for an eighteenth hike, with about a 30 percent probability of a hike over the next three months, vs. a better than 50-50 bet previously. The interest-rate market clearly is anticipating a more relaxed Fed given the growth and inflation mix.

Maximum flexibility
The bond market had already done a lot of the heavy lifting, however, in anticipation of a pause. Indeed, the yield curve is pricing in an eventual cut in the target rate, with the entire curve trading below 5 percent, compared to the 5.25 percent funds target in the week leading up to the well-discounted decision. The benchmark 10-year yield typically trades at a modest inflation premium to the Fed funds target during the second half of business cycles, so the bond market and Fed may be somewhat at odds over the economic outlook.

The fairly subtle adjustments to the policy statement left the Fed with the maximum flexibility it sought, though dissension among the ranks and its own data dependency could point to a resumption in tightening ahead. For now, we at Action Economics expect economic and inflation risks to rebalance and the Fed to remain sidelined in September.