US markets see Fed hint of lower rate

US markets see Fed hint of lower rate
By Krishna Guha in Washington and John Authers in New York
Copyright The Financial Times Limited 2007
Published: March 21 2007 18:20 | Last updated: March 21 2007 23:54


The Federal Reserve said on Wednesday it remained focused on inflation rather than growth but qualified its bias towards tightening monetary policy, sparking a rally in stocks and bonds.

The statement, released after the Fed’s March policy meeting – which kept rates on hold at 5.25 per cent – highlights continuing differences between the US central bank and financial markets over economic prospects.

But while policymakers retained their tightening bias, they changed the language of their statement to qualify it and give themselves flexibility.

The market emphatically interpreted this as a signal that the Fed was opening the door to the possibility of interest rate cuts.

Within an hour of the statement, the dollar had slipped to its lowest level against the euro in two years. The S&P 500 closed up 1.7 per cent, while the yield on two-year Treasury bonds fell 8 basis points.

The Fed funds futures market priced in a near-even chance that the first rate cut will come by June, with two quarter-point cuts by year-end. The statement said “the committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected”.

This is hard to square with market expectations that the Fed will soon be in rate-cutting mode.

However, the Fed dropped its explicit reference to the possibility that “additional firming” might be required. Instead, the Fed used the phrase “policy adjustments” to describe its next steps – words that could mean movements up or down. This sparked vigorous debate in the markets as to whether the Fed still had a tightening bias or not.

Ian Shepherdson of High Frequency Economics argued that “the Fed has dropped its explicit tightening bias”. But John Ryding of Bear Stearns said “the essential thrust of the bias was unchanged”.

A careful reading of the statement suggests that the Fed does retain a tightening bias, though it is considerably more qualified than before. The Fed has greater scope to move quickly to cut rates if growth turns out weaker than anticipated. However, the statement suggests the Fed has not changed its base case outlook for the economy much.

The Fed marked down its description of current economic conditions, noting that “recent indicators have been mixed”. And it dropped a reference in the previous statement to “tentative signs of stabilisation” in the housing market.

But it did not change its description of US prospects, declaring “nevertheless, the economy seems likely to expand at a moderate pace over coming quarters”. The Fed’s use of the term “mixed” rather than “weak” or “soft” to describe recent economic data is a sign that it is still fairly confident that the basic engine of growth remains on track.

Additional reporting by Richard Beales and Michael Mackenzie in New York