Tea Leaves

2 February 2004


Fed Watchers Panic and Sell

The Fed held interest rates at their lowest levels for decades, and the market decided to sell off. The pretext was a change in the language the Fed used in describing its future plans for interest rates. Rather than keep them low for a "considerable period" as it has promised in recent Open Market Committee statements, the Fed last week said it would be "patient" in raising interest rates. It is too early to say this is a change in policy.

The Fed, like any central bank worthy of the name, is in the business of managing expectations as well as managing currencies and interest rates. By changing the language of the statement that followed the FOMC meeting, the Fed did not do anything to alter economic realities. The sell-off was the result of psychological changes the new language prompted. The change sparked a sudden caution among market participants. Which is precisely what the Fed wants right now.

The American economy is growing and that means that it will eventually see some inflationary pressures. The timeframe here is imprecise, but the economic law is that an economy growing will eventually overshoot, and too much money will wind up chasing too few goods. When the economy begins to feel these pressures, the Fed is anxious to ensure that it does not have to step too heavily on the brakes by raising interest rates too far too fast. The auto analogy applies; the brakes have to be used less to slow a car that is not zooming out of control.

By telling the market that rates are going up some day, those inflationary pressures will appear later rather than sooner because the markets are acting more cautiously than if the Fed left its language unchanged. Speculation at the extreme end of the risk spectrum diminishes, and that will mean that money doesn't get too far ahead of goods and services.

It is a subtle game, and the market's sudden sell off was proof that, as a group, investors aren't terrible subtle. The Fed, by changing the language now, has bought itself some extra time before it needs to raise rates and when it does, it will be able to get away with 25 basis points instead of hiking rates by 50.

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