Fed Lifts Rates 25 Basis Points, But Removes Tightening Bias
As widely anticipated, the Federal Open
Market Committee raised its key target for
the federal funds rate by 25 basis points to
5.0% at the conclusion of today's policy
meeting. It left the largely symbolic discount
rate steady at 4.5%.
The rational for the move appears simply to
take back part of the 75-basis-points rate
cut of the fall because the motivation for
easing – capital market turmoil and weak
external demand – no longer applies. The
Fed's press release said that the "full
degree [of the fall easing] is judged no
longer necessary."
Much to the surprise of financial
markets, the Fed switched its policy bias
for the inter-meeting period from
tightening to neutral. The symmetrical
directive reflects "no predilection about near-term policy actions." In our view, this does not imply that
further rate hikes are deemed unnecessary. In fact, the Fed usually switches to a neutral bias after
raising rates, a pattern adhered to at the previous five FOMC meetings in which rates were actually
raised. The neutral directive simply means that the Fed sees little need to adjust rates prior to the next
meeting on August 24. This is consistent with Greenspan's June 18 speech when he alluded to the
need for "modest" pre-emptive actions.
However, a neutral bias does give the Fed a little more wiggle room than a tightening bias. The Fed can
pass-up on a rate hike at the August meeting should the upcoming data point to slower growth. As a
result, the Fed's neutral bias, coupled with a sense that Greenspan is not predisposed to
unwinding all of the fall easing, dampens slightly the odds of a rate hike in August.
Despite the removal of the tightening bias, the press release suggested that the Fed still thinks the
longer-term risks are skewed towards higher inflation. It noted that policymakers "must be especially
alert to the emergence, or potential emergence, of inflationary forces." In our view, growth is unlikely to
slow significantly to ease the Fed's concern about an eventual outbreak of inflation. Therefore, we
believe rates will be upped again at the August meeting.
Following the August meeting, we expect the Fed to tighten a further 75 basis points before the middle
of 2000. In our view, growth will continue at a 3%-plus clip this year, above the Fed's presumed
inflation-safe pace, putting further pressure on labour resources. In response to tight labour markets and
an unwinding of special factors that have damped prices in recent years, inflation is expected to rise
about one percentage point in the year ahead.
Financial markets rallied on news that the Fed had removed its tightening bias. Yields on 2-year
Treasuries dropped 14 basis points, while rates on 3-month issues eased 6 basis points. The Dow
swung from down 45 to up 122 by 3:00 p.m. EDT.
In Canada, money market rates plunged and the Canadian dollar soared following the Fed's
announcement. The currency strengthened from C$1.4700 to C$1.4620 by late afternoon. The stronger
currency eliminates any chance of a rate hike by the Bank of Canada in the near term.
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