US Rates: The Reaction

As expected, the outgoing chairman of the US Federal Reserve, Alan Greenspan, last night announced an increase in US interest rates by 25 basis points to 4.5%. There were strong indications the move will not be the last in the current tightening cycle now in the hands of incoming chairman Ben Bernanke.

GERARD MINACK at Morgan Stanley:

So he’s gone, and with the universally predicted 25 point bang. But to anyone but a 5-tick trader, my view is that Greenspan’s departure makes almost no difference to the outlook for the foreseeable future.

In particular, the shift in the wording of the overnight FOMC statement confirms that future policy moves now depend on incoming data. But there’s no reason to think that Mr Greenspan’s crystal ball was any sharper than Mr Bernanke’s will be. (Remember how the FOMC maintained a tightening bias up until the November 2000 FOMC, but then delivered an inter-meeting rate cut in the first week of January 2001 as the economic data turned soft.)

Of course, in a tight corner, Bernanke may behave differently '” as hinted at by his famous printing press speech of November 2002. But we’re a fair way from that extreme scenario. And in any case, Alan Greenspan was no slouch at opening the monetary sluices, even in far less trying circumstances than Bernanke was speculating about.

And while Alan Greenspan, aka The Maestro, leaves with an apparent A-grade track record, it seems to me too early to deliver a final judgement. If, as I suspect, he’s bequeathed a dangerous bubble, his legacy may not look so grand in five years. In any case, the past 15 years have been a great time to be a central banker, particularly in an Anglo-economy. To be a champion coach you need a champion team, and successful economies make central bankers successful.

Having said all that, Greenspan was the world’s first celebrity central banker. Whether that fame made his economic stewardship easier, by ensuring that investors gave him the benefit of the doubt, is a moot point. Only time will tell if markets behave differently in the post-Greenspan era.

For now, however, the near-term outlook will depend on your view of incoming data. The economy seemed to bounce nicely through the December quarter, and our US economics team now expects March quarter GDP to be around 5.5%.

Moreover, there seems a good prospect of punchy near-term data, partly because of weather effects. Stone & McCarthy have noted that January 2006 is shaping up as the warmest January in the US since national records commenced in 1895. As December was actually unusually cold, the temperature swing was very large. This could affect a number of partial indicators, including Friday’s payroll report. (The last time there was a comparable temperature swing the construction sector added more than 100,000 jobs in the month.)

All that may mean that the current rate expectations '” which have turned slightly more hawkish over the past week '” will price in even more Fed moves through this year.

In my view, that’s a sell-off to buy. With growing signs that the housing market is cooling, I’m getting more convinced that consumer spending will surprise on the low side in the second half of this year. In short, the current futures pricing looks right to me, or even a little too high (in yield terms).

The one risk to this is if labour costs start to push higher. The overnight Employment Cost Index showed wage and salary payments rising at the margin, following the lead from the hourly earnings series. But these numbers are still too low to prevent the FOMC ending the tightening cycle if growth slows, as I expect.

ROBERT DI CLEMENTE at CITIGROUP:

With today's hike to 4.5%, the FOMC said and did enough to keep market expectations focused on the risk of further tightening. As expected, the committee backed away from the forward-looking guidance that has accompanied all previous moves in this cycle. Nonetheless, the statement left the door wide open for a March hike, without promising a move. We have not expected action beyond today and although data and events have tilted in favor of 4.75%, officials will want a much closer look at how the inflation forecast evolves in coming weeks.

Despite today's announcement, the Fed appears to have hurdled safely the risk of prematurely capping rate expectations. We expected that guidance about further tightening would be downgraded from "likely to be needed" to "may be needed". But the statement counterbalanced that on several counts. It downplayed recent weak fourth quarter growth by characterising expansion as still "solid". And, importantly, the committee highlighted continuing inflation risks to the upside from declining slack and high energy costs.

Markets speculated whether the committee's hedging was motivated by a desire to give incoming chairman Bernanke flexibility. But this view is probably overdrawn and it's important to know why. Bernanke' s viewpoint almost certainly was infused in the committee discussion and final decision. Regardless of leadership, the outlook for rates has been clouded because policy has become less accommodating, core inflation and cost pressures remain contained and it's unclear whether the Fed must risk an overshoot given the uncertain strength of demand in the months ahead.

SAUL ESLAKE at ANZ:

This month ANZ revised its forecast for the top of the US Fed funds rate to 4.75% (from 4.5% previously) at the March 2006 meeting. We have moved forward our expected RBA rate hike to 5.75% from October to June 2006, but think stable inflation will negate further moves.

THE FOMC (Federal Open Market Committee):

The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 4.5%. Although recent economic data have been uneven, the expansion in economic activity appears solid. Core inflation has stayed relatively low in recent months and longer-term inflation expectations remain contained. Nevertheless, possible increases
in resource utilisation as well as elevated energy prices have the potential to add to inflation pressures.

The committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the committee will respond to changes in economic prospects as needed to foster these objectives.