- The Washington Times - Monday, March 26, 2007

When the Federal Reserve’s policy-making committee announced Wednesday afternoon that it had decided to maintain its target short-term interest rate at 5.25 percent, the Fed issued a press release that seemed to have something for everybody. In several key respects, the statement also departed from the committee’s preceding press release, which was issued Jan. 31. During the hour and 45 minutes that remained in the trading day after the Fed issued its statement, the Dow Jones Industrial Average soared 160 points. A roar literally erupted on the trading floor of the Chicago Board Options Exchange when the Fed’s statement hit the ticker. The yield on the 10-year Treasury Note dipped to nearly 4.5 percent.

The financial markets clearly welcomed the Fed’s apparent shift to a neutral policy position. The markets inferred that shift from the fact that the Fed’s statement declared that “[f]uture policy adjustments” — i.e., changes in its target interest rate — “will depend on the evolution of the outlook for both inflation and economic growth.” Indicating an inclination to raise its target interest rate at some point in the future, the six previous Fed statements from June through January pointedly referred to “additional firming that may be needed to address” inflation risks. “Firming” is synonymous with monetary tightening and rising short-term interest rates. By removing “additional firming” from its statement last Wednesday, the Fed signaled that the next movement in its target interest rate could be downward.

For those concerned that the pronounced slowdown in economic growth during the past year could soon approach the danger level, the Fed acknowledged that ” ecent indicators have been mixed” and that “the adjustment in the housing sector is ongoing.” Its Jan. 31 statement had cited “somewhat firmer economic growth,” while noting that “some tentative signs of stabilization have appeared in the housing market.” Those hopeful signs took some big hits since then. The Commerce Department revised downward its estimate of fourth-quarter growth from 3.5 percent to 2.2 percent. And, of course, the subprime mortgage market imploded.

Notwithstanding its apparent shift to neutral, the Fed gave inflation hawks more than enough red meat to chew on. Having reported in January that core inflation “improved modestly in recent months,” the Fed admitted last week that ” ecent readings on core inflation have been somewhat elevated.” Then the Fed flatly asserted that its “predominant policy concern remains the risk that inflation will fail to moderate as expected.”

Our reading is that the financial markets deliberately ignored the Fed’s “predominant policy concern.” If growth continues to soften, as is likely, and if inflationary pressures should simultaneously intensify (due perhaps to a precipitous drop in the dollar), the Fed would likely react in a way that the markets did not anticipate last Wednesday.

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