A Little Hint of Hike

Chances are about nil that the Federal Open Market Committee will change its 1 percent overnight rate target later today, but that doesn’t mean the panel’s announcement will be any less-closely scrutinized.

In the wake of the credit market wipe-out — precipitated in part by an abrupt shift in Fed expectations following the late-June meeting that put the funds rate at new 45-year lows — badly burned market players are still hoping against hope that the Fed somehow will toss them a lifeline. That seems highly improbable.

Rather than hinting at the possibility of further ease, or even assuring that they will remain “on hold” as far as the eye can see, policymakers are more likely to gently begin prepping the market for the inevitable rollback of the 30-month, 550-basis-point rate-cutting cycle.

For the most part, that is as it should be. The reversal in Treasuries marks a return to more normal levels from an excessive depression in yields fostered by a spooked central bank that managed to convince the market that deflation was a real threat. In reality, the dollar’s reflation against sensitive market-price indicators confirmed that by the time deflation showed up on the Fed’s screen, it was yesterday’s news.

Consider the anomaly that at the peak of the bond rally — June 13, with the 10-year Treasury yielding 3.11 percent — the trade-weighted dollar was at its lowest point against the other major currencies since late 1998, down nearly 25 percent from its levels early last year. A 1 percent funds rate against a reflated dollar is no less anomalous. If putting the rate target at this level was an extraordinary step meant to guard against the risk — however remote — of a deflationary episode, that risk convincingly has been neutralized.

From the Fed’s demand-management perspective, it would take a denial of the obvious — that the economy is in the midst of significant acceleration — to sustain the rationale for keeping rates at these levels much longer. Recall that in his July 15 testimony that so roiled the market, Alan Greenspan told the House Banking Committee that the Fed was “prepared to maintain a highly accommodative stance of policy for as long as needed to promote satisfactory economic performance.” [Emphasis added.] Barring a sudden, and unlikely, reversal in the pace of the economy’s pick-up, the accumulating evidence certainly suggests that by that standard, the Fed’s current posture will become increasingly difficult to justify.

In addition, the last two FOMC statements highlighted the panel’s concern about the possibility of an “unwelcome substantial fall in inflation,” but that risk appears to be waning. Since March, the core personal-consumption price deflator, the Fed’s favored measure of statistical inflation, has gone from rising just 0.78 percent at a three-month annualized rate to more than 1.15 percent. Accounting for the lags in the deflator responding to the dollar’s softening against foreign exchange, gold, and broader commodity indexes over the past 18 months or so, a further stanching of the “disinflation” trend is practically assured.

That said, given the grief they’re now taking for pulling the rug out from under an overstretched bond market, the central bankers will no doubt want to exercise considerable care moving toward the inevitable rate-hiking exercise. At this point, the Fed’s foreshadowing of an approaching change in course will likely be limited to some shift in phrasing toward a moderately more optimistic outlook. After tomorrow, the FOMC will still have three scheduled meetings before the end of the year. Expect the first tightening move to come no earlier than the December 9 meeting, and perhaps be put off until the first quarter of next year.

— David Gitlitz is chief economist of Trend Macrolytics LLC , an independent economics and investment-research firm. Mr. Gitlitz welcomes your comments at dgitlitz@trendmacro.com.