Fed’s June Meeting Takes on Critical Importance

Investors will look to signs of changes in easing policy

     

Earlier, I mentioned that the Federal Open Market Committee is in fact a committee. Well, there’s an unrecognized member of the committee who has the most important vote of all, and that’s the market. It’s interesting to note that the S&P 500 peaked in May at the exact time that Ben Bernanke told a congressional committee that the Fed could start winding down its bond buying.

Apparently, the Fed is scared that it’s scaring the market. So yesterday afternoon, just before the market closed, Hilsenranke came out with another article. In it, he conveyed the Fed’s caution to investors not to overreact to any adjustments to their bond buying. Easier said than done. It’s like a teenager calling his parents and opening with, “don’t overreact.” Whatever may follow, it probably ain’t good.

Again, I think these comments are coming right from Bernanke, and I understand his concern. The financial markets are clearly worried the party is about to end. The long end of the bond market is already factoring in higher interest rates, and that’s why interest-rate stocks lost favor.

But here’s the thing: This is really the same story we’re seeing in Japan, just not as dramatic. Investors think the Fed isn’t fully committed to propping up the market. The Fed has said that it won’t raise short-term interest rates until unemployment gets to 6.5%. We’re at 7.6%, which is a long way away. Most economists think that at best, we won’t get to 6.5% until 2015. Still, the futures market for interest rates expects increased rates before then. In short, that unrecognized voting member of the Fed might exercise its power of veto.

Interestingly, in last week’s CWS Market Review, I mentioned how “tapering” had become Wall Street’s favorite buzzword. Well, Hilsenranke had another article from last Friday saying that the Fed really hates the word “tapering.”

The hangup for Fed officials is the word “tapering,” which suggests a slow, steady and predictable reduction from the current level of $85 billion a month at a succession of Fed meetings, say to $65 billion per month, then to $45 billion and so on. And that’s not necessarily what Fed officials envision.

Because Fed officials are uncertain about the economic outlook and the pros and cons of their own program, they might reduce their bond purchases once and then do nothing for a while. Or they might cut their bond buying once and then later increase it if the economy falters. Or they might indeed reduce their purchases in a series of steps if warranted by economic developments — but they don’t want the markets to think that’s a set plan. It is, as Fed officials like to say, “data dependent.”

Hmmm. This strikes me as a bit pedantic. With interest rates, Fed policy almost always follows a trend. It stands to reason that bond buying will be similar.

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