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To: NickSE who wrote (58697)	8/25/1999 9:48:00 PM
From: Giordano Bruno	Respond to of 86076

— this is a market that has long wanted to believe that the Fed is done. But is it? I remember all too well how most of us were led astray by a similar line of reasoning in early 1994. Back then, the Fed was viewed very much as it is being perceived today — operating in a "pre-emptive" mode in order to stem potential inflationary pressures. Seven tightenings and 300 bps later, the concept of the pre-emptive tightening looked a little less benign that it was thought to be at the time. If anything, the macro risk factors in 1999 should be viewed as more worrisome for the Fed than they were five years ago. Global: Another Easing By Stephen Roach, Chief Economist Morgan Stanley Dean Witter ------------------------------------------------------------------------ Once again, financial markets have responded favorably to a Federal Reserve rate hike. As was the case in the immediate aftermath of the June 30 action, the yield curve has flattened on the heels of the August 24 move. Fed funds futures now imply only a 33% chance of a following action at the next FOMC meeting on October 5. The verdict looks unmistakable — investors now believe the monetary tightening cycle is virtually complete. Nor can market participants be accused of grasping at straws. As our Fed watcher, David Greenlaw, points out, fixed income markets have taken their cue from the Fedspeak that accompanied the latest action. The accompanying action on the discount rate notwithstanding, one phrase in the announcement said it all: The Fed was explicit to note that the combined effects of the late June and August rate hikes ". . . should markedly diminish the risk of rising inflation going forward." This suggests the central bank now believes that 50 bps of tightening will be sufficient to hold the line on inflation. Such spin was comparable to that which supported the markets in late June, when the Fed made a "surprising shift" to a symmetrical policy bias. The conclusion back, then, of course, turned out to be dead wrong — policy neutrality is often a poor predictor of subsequent actions. But never mind this reality check — this is a market that has long wanted to believe that the Fed is done. But is it? I remember all too well how most of us were led astray by a similar line of reasoning in early 1994. Back then, the Fed was viewed very much as it is being perceived today — operating in a "pre-emptive" mode in order to stem potential inflationary pressures. Seven tightenings and 300 bps later, the concept of the pre-emptive tightening looked a little less benign that it was thought to be at the time. If anything, the macro risk factors in 1999 should be viewed as more worrisome for the Fed than they were five years ago. Today's unemployment rate of 4.3% is well below the 6.6% jobless rate prevailing in early 1994. Moreover, the US economy is now in the midst of a third year of 4% GDP growth, well in excess of the three-year trend of 1.4% that was prevailing at the start of 1994. In other words, today's US economy is "white hot" when compared with that which the Fed confronted some five years ago. To the extent that any linkage between growth, unemployment, and inflation remains intact, the Fed could still have plenty of work to do in the months ahead. Financial markets have, of course, largely disengaged from this thought process. Inflation and interest rate risks are no longer perceived as being tied to an economy's growth potential or labor market dynamics. The lack of global pricing power and/or a new era of technology-led productivity enhancement are typically cited as the missing link(s) to a new paradigm that keeps inflation down, irrespective of traditional macro warning signs. Backward looking results on the CPI and PPI tend to confirm this perspective, especially the benign reports on core inflation that have been evident this summer. Against that backdrop and with the added hope of the latest in a long string of slowdown bets, the Fedspeak of August 24 seems all that battered bond investors could have hoped for. On the heels of a sharp correction in the first half of 1999, yields on long Treasuries have now moved slightly through the lower end of the 6% to 6.25% trading range that has prevailed since early June. The hope is that the correction was nothing more than a big accident and that bond yields will fall sharply further, possibly toward 5.5%. While anything is possible in these momentum-driven markets, I continue to look for bonds to return to the range that has prevailed over the past three months. Cyclical inflation risk should not be dismissed out of hand — especially with the dollar listing to the downside, productivity growth slowing, wage inflation inching upward, and the manufacturing sector now on the mend. Moreover, global healing paints a picture of an export rebound that is just around the corner, thereby adding new impetus to US economic growth; this worldwide revival also hints at an important inflection point in pricing leverage, as a revival on the demand side of the equation begins to catch up with judicious reductions that have been occurring on the supply side. In short, as I see it, the odds continue to favor a modest cyclical acceleration in inflation that the Fed will ultimately judge to be actionable from a policy perspective. Consequently, with another 25 bps to go in the post-crisis normalization drill and a gradual updrift in inflation about to set in, I continue to believe it is wrong to conclude that the Fed is done. Our view is once again clearly out of favor — not just in the financial markets but also in the marbled corridors of the Federal Reserve. What I find particularly curious in this climate is the Fed's willingness to give yet another green light to an overvalued stock market. As was the case on June 30, the Fed knew full well that equity investors could take kindly to an "all clear" sign on the interest rate front. The central bank's fears of an asset bubble seem to have vanished into thin air. Such is the silver lining of the latest rhetorical easing. Courtesy of the Fed, there's no stopping the bull.