The Fed Blinks, or Winks?

The Federal Reserve raised their benchmark interest rate for the 17th consecutive time yesterday which was a surprise to no one.  But in a surprise to many, they suggested for the first time that a pause might be coming soon.  Their statement said “the extent and timing of any additional” rate increases “will depend on the evolution of the outlook for both inflation and economic growth.” Stock markets surged on the news.  The Dow Jones Industrial Average soared to close 217.24 points higher than when the statement was released, a gain of about 2% – its best day in more than three years. The NASDAQ Stock Market was up 3%, its biggest one-day rally since March 2004. Long-term bond yields edged down as prices rose.

In contrast, the Fed’s May 10th statement said “some further” rate increases “may yet be needed.”  The Dow Jones Average fell 1.2% that day and declined a further 800 points or 7.6% in the following weeks until June 14th when buyers began coming back into the market.  Investors that feared the Fed might go too far may now be encouraged that they will not and the economy will continue its growth.  All of course depends upon whether or not it inflation pressures continue.

Mr. Bernanke’s Fed may be doing what Mr. Greenspan’s Fed did before him; that is, pause the rate increases though inflation pressures are still rising with the assumption that their effectiveness lags.  They may believe too that further increases are unnecessary and unduly threaten the growth of the economy.  If it was their intention to pause all along, it might better explain the deluge of Fed jawboning that flooded the financial press during May and June which was highlighted in the Friday Brief No. 219.  If Mr. Bernanke wanted to pause all along to avoid risking the economy, but couldn’t afford loosing credibility as one soft on inflation, the talk may have accomplished his objective.  If indeed the world takes him and Fed governors at their word, that they will do whatever it takes to contain inflation, then further rate increases may not be necessary.  The ‘Goldilocks’ economy can continue growing as inflation recedes back into obscurity.   We will be watching.