'Fed in denial' jars stocks - Focus on inflation triggers sell-off

'Fed in denial' jars stocks - Focus on inflation triggers sell-off
Bill Barnhart
Copyright © 2007, Chicago Tribune
August 29, 2007


Stocks fell hard Tuesday, as the latest statement by the Federal Reserve prompted a rush of complaints from normally even-tempered and conservative market analysts.

The spark to the afternoon sell-off was the release of minutes of the Fed's Aug. 7 meeting, at which the central bank, in a nine-page summary, acknowledged the risks of an economic slowdown, but stuck by its view that "the risk that inflation would fail to moderate as expected continued to outweigh other policy concerns."

"Either they misrepresented the facts as they were or they have a heavily biased preference to deal with inflation above everything else and almost to the neglect of everything else," said veteran Fed watcher David Resler, chief economist at Nomura Securities International.

The Dow Jones industrial average tumbled 280.28 points, or 2.1 percent, to 13,041.85. The move, added to Monday's 56-point drop, wiped out last week's 300-point gain. All 30 stocks in the Dow fell. Broader market indexes posted bigger percentage losses.

Treasury securities rallied strongly, as investors sought safe harbor from stock market volatility. The yield on 10-year Treasury notes has dropped to 4.52 percent Tuesday from 5 percent in mid-July.

"We had our biggest problems after the Fed minutes were released," said Jack Ablin, chief investment officer for Harris Private Bank. "What took the biggest hit after Merrill Lynch downgraded its investment ratings on Citigroup, Lehman Brothers and Bear Stearns, three of the giant Wall Street financial firms holding billions of dollars in troubled loans earmarked for mergers and acquisitions.

The KBW index of 24 commercial bank stocks lost more than 3 percent. The Standard & Poor's index of major investment banking stocks dropped more than 4 percent.

"This is a Wall Street event that is turning into a Main Street event," said Jerry Webman, senior investment officer and chief economist at Oppenheimer Funds. "As the financial markets shake, consumer confidence is faltering."

Indeed, Tuesday's stock market's decline began with a monthly report showing consumer confidence at the lowest level of the year in August, though the reading was higher than in August 2006.

Quick to assign blame

Commentators were quick to pin Tuesday's stock market troubles on Ben Bernanke, the Federal Reserve chairman, who is in his 18th month at the helm of the Fed and is facing the first crisis of his tenure.

"You've got a new Fed chairman with his own personality and his own biases," said Ablin. "This is unchartered territory. It's like an election when you don't know what the new administration is going to do."

What the Fed has done in recent weeks is stick to its long-standing vigilance against inflation, though the central bank acknowledges that a general rise in prices in the economy has been moderating for some time.

Asleep at the switch?

Meanwhile, a historic slump in the housing market, rare declines in house prices and a global credit crunch affecting many industries have threatened to reverse this year's economic growth.

The minutes of the Fed's Aug. 7 interest-rate policy committee meeting contained no shocking disclosures. As usual, the result of the meeting was published in a brief statement by the committee on that day. But the more lengthy analysis in the minutes, released Tuesday, aggravated experts' fears that the Fed might be asleep at the switch.

Minutes called baffling

"My skepticism about whether the Fed was on the ball increased exponentially on Aug. 7," Resler said. "Then, upon reading the minutes, I'm even more baffled."

Having failed to adequately present the evidence of threats to the economy three weeks ago, the Fed might feel obliged to stand by its assessment, he said. If the Fed moderated its inflation vigilance, "it will be seen not as a reaction based on a changed economic outlook but a reaction to market circumstances."

In fact, recent trading in futures contracts based on the federal funds rate, the rate banks charge one another for overnight loans, suggested that traders had become less convinced that the Fed would cut the benchmark rate at its next policy meeting, scheduled for Sept. 18.

"You combine economic deterioration with a Fed that might be digging in their heels, and that creates frustration," said Ablin.

Bernanke is scheduled to speak about housing and the economy Friday at an annual meeting of Fed officials at Jackson Hole, Wyo. Analysts do not expect the Fed chief to reveal his next move.

"I don't expect him to reveal anything," Resler said, adding, "Frankly, he has done a good job. He's been a better communicator than his predecessor [Alan Greenspan], but the Fed had dropped the ball in the last month."

Still, the stock market has been relatively calm compared with the credit market, Resler said. Major indexes still have not suffered a 10 percent decline, based on closing prices.

"The only way to attract the man-on-the-street's attention or the media's attention is if the stock market gets hammered, but the credit markets have been close to dysfunctional throughout the last couple of weeks," said Resler. "That dysfunctional market is going to matter a great deal more to the economy that what's going on in the stock market."

Webman said the instability will subside when well-capitalized investors, who do not use debt to invest, sense bargains. But "if fear overtakes prudent risk-taking, than many economies will be in for a rough time," he said.

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bbarnhart@tribune.com

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