Wednesday, June 27, 2007

The Short View By John Authers - The Federal Reserve is back in conclave

The Short View By John Authers - The Federal Reserve is back in conclave
Copyright The Financial Times Limited 2007
Published: June 27 2007 03:00 | Last updated: June 27 2007 03:00

The Federal Reserve is back in conclave. The Federal Open Market Committee, which sets monetary policy, convenes today for its first meeting since the bond market sell-off drastically raised long-term interest rates.

Bonds remain volatile, but the yield on the benchmark 10-year bond seems to be stabilising at about 5.1 per cent, after briefly passing 5.3 per cent. Confusion reigns over what this sell-off implied about growth, inflation, and the Fed's intentions.

This month's Merrill Lynch survey of fund managers found sharp increases in the growth they expected for this year, and in their inflation expectations. Most thought monetary policy too lax, while 47 per cent expected inflation to increase.

But the prices of index-linked bonds never suggested any particular inflation "scare" in the market. And the futures market now appears to be of a very different mindset. At one point, it briefly signalled a tiny chance of a Fed rate rise later this year, but that has swung back. It now implicitly puts the odds of a Fed rate cut by the end of this year - exactly the opposite of what would be implied by the bond sell-off - at about 40 per cent, the highest in more than a month.

Yesterday, poor US housing and consumer sentiment figures helped further to douse worries that growth might be about to take off, taking inflation with it.

There is almost no chance that the Fed will tomorrow change the Fed Funds rate, the rate at which it lends to banks. It would have signalled its intentions long ago if there were any chance it would do this.

But it will offer its opinions on growth and inflation. After its last meeting, it said inflation was its "predominant" concern. Removing that word, or rewording its description of core inflation as "somewhat elevated", could prompt a big rethink in the bond market.

It also said it expected "moderate" growth for the rest of this year. If it chooses to be more optimistic, that could trigger another bond sell-off.


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