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July 01, 2005

The June 30 FOMC Statement and How it Differs from the May 3 Statement
by Ashraf Laidi

The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 3-1/4 percent.

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. Recent data suggest thatAlthough energy prices have risen further, the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices. Laborexpansion remains firm and labor market conditions, however, apparently continue to improve gradually. Pressures on inflation have picked up in recent months and pricing power is more evident. Longerstayed elevated, but longer-term inflation expectations remain well contained.

The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.

The chart exposes 2 clear conclusions:

1. the current Fed tightening campaign has reached the same duration of the last 2 tightening campaigns, i.e. 12 months (Feb 94-Feb 95) and (June 99-May 00)
2. The real fed funds rate (Fed funds - annual Core CPI) has now reached 1.05%, still below the last month of each of the last aforementioned tightening campaigns at 3.03% and 4.12%.

Those who expect further rate hikes can easily point to the second conclusion stating that the real fed funds rate has yet to reach at least 3.0%. But with oil prices rising 58% since last June (when rates started rise) and with US manufacturing nearing contraction, the bond market is telling the Fed that it had better not raise rates further. The other latent message from teh Fed is that the central Bank remains data dependent. Fed Charmain Greenspan will use the semi annual testimony on July 20 to comunicate his latest thinking about the economy, which will be the equivalent of an FOMC meeting as far as managing market expectaions. Until then, fed funds futures will depend on the key market data such as whether tomorrow's ISM manufacturing survey will echo today's 2-year low in the Chicago PMI.

It is no surprise that the 10-year yield fell to 3.91% from 3.99% after today;s rate hike. The Fed needs to STOP tightening in order to see push up long yields up and to start containing the housing market. The so-called conundrum can also work the other way. Once the Fed holds off, bond vigilantes could start to fret about the Fed possibly being behind the curve and push up long yields. That should accelerate the US Treasury's decision to bring back the 30-year bond before the long end starts to push higher. Meanwhile, the Fed is doing a great service for the US Treasury by raising the short end in order to flatten the long end and facilitate the issuing of cheaper long term debt.

Ashraf Laidi
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