ANALYSIS-Cautious U.S. Fed may
fall behind curve
By Knut Engelmann
WASHINGTON, July 1 (Reuters) - As the euphoria over the
U.S. Federal Reserve's modest interest rate increase faded on
Thursday, investors reassessed the inflation outlook for the
world's top economy -- and they didn't like what they saw.
On Wednesday, the U.S. central bank had nudged a key interest rate up by a timid
quarter-percentage point but surprised financial markets by leaving open whether further rate rises
would be needed in the future to quell inflation.
Just a day later, observers were wondering whether powerful Fed Chairman Alan Greenspan
risked falling behind the curve with this cautious move that some described as half-hearted.
''They should have sent a stronger signal,'' said Sung Won Sohn, chief economist at Wells Fargo
Bank in Minneapolis. ''This slow-motion monetary policy could be contributing to more inflation
and more uncertainty. We're going to pay for it.''
Financial markets sobered up on Thursday after initially surging on the Fed's seemingly optimistic
inflation outlook contained in a brief statement announcing the rate increase. Inflation-sensitive
bond prices plunged amid renewed fears that the red-hot U.S. economy is about to bubble over.
Adding fuel was a report by U.S. purchasing managers that said fresh demand from overseas,
along with unabated domestic consumer and business spending, had pushed U.S. manufacturing
activity in June to its highest level in two years.
''The market is now reevaluating what the Fed is going to do,'' said Joel Kent, economist at
Lehman Brothers in New York.
The manufacturing sector had been badly hit by a global financial crisis of the past two years, as
U.S. exports to crisis-ridden economies in Asia and elsewhere plunged. But all that appears to be
history now.
''The manufacturing sector is accelerating and there no longer are any weaknesses in the
economy,'' said Joel Naroff of Naroff Economic Advisors in Holland, Pa.
The economic recovery in many emerging markets is expected to increase the demand for U.S.
products. But that could push up inflation since domestic demand, driven by free-spending
consumers that have made money in the exuberant stock market, is already at levels few think will
be sustainable.
In its statement, the Fed pledged to keep a close eye on the economy for any signs of overheating.
But in an unusually upbeat tone, it added that rising U.S. productivity had contained inflation
despite ever-tightening labor markets that have been widely expected to heighten wage and price
pressures.
''I was a little surprised by the content of the statement,'' said Dana Johnson, managing director
and head of research at Banc One Capital Markets in Chicago. ''It was more cautious and a little
less hawkish than one might have thought.''
What struck financial markets most was that the Fed said it had adopted a neutral stance on the
future direction of interest rates and was no longer leaning toward higher rates. The move
suggested that Fed officials may think one rate rise could be sufficient to keep the economy out of
trouble.
But Johnson warned not to underestimate the extent of Greenspan's concern over rising inflation
that could still prompt him to opt for a rate rise when the Fed's policymakers next meet on August
24. ''Greenspan told you very clearly that he is worried,'' he said.
Economists agreed that whether or not the Fed will follow up Wednesday's modest rate rise with
more of the same in August will almost entirely depend on the economic data that will come in
between now and then.
Key among those will be Friday's June employment report, widely seen as the most crucial
indicator of the U.S. economy's health. Should the unemployment rate drop further from what is
already its lowest level in three generations, the pressure on the Fed to deliver more rate rises will
certainly increase.
''Greenspan added fuel to the red-hot economy,'' said Sohn. ''If the economic numbers, including
the jobs report, come in strong the probability of a hike in August has increased.''
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