Fed's Next Move? The Answer's In The Action

Before getting into the nuances of the statement, it’s important to not lose sight of the overall action: for the first time since the Fed began cutting rates in September — by 3.25 percentage points in total — the Fed stood pat today. That is probably a clearer indication of what the Fed will do next than anything the Fed said.

Now to the Fed-ology. Probably the best way to read the substantial changes to the Fed’s policy statement is that they laid the groundwork for a possible rate hike if they feel one is needed and yet didn’t guarantee a hike at all.

The most important addition to the statement was to upgrade the growth outlook and downgrade the inflation outlook: “Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased.”

Note that the sentence does not say that inflation risks are greater than growth risks. In such a situation, the Fed would be lead almost inevitably towards rate hikes and soon. It simply says that inflation risks are higher and growth risks are lower. You can’t know whether the Fed views inflation as the greater threat, in part because other parts of the statement note that “labor markets have softened further and financial markets remain under considerable stress.” That’s pretty powerful downside stuff to match the inflation concerns.

Even more vexing, the Fed gave inflation a little more time to come down before it feels it has to act. The current statement says that “the Committee expects inflation to moderate later this year and next year.” The prior statement said “coming quarters.” Bottom line is that the Fed has heightened its inflation concerns but also suggested it’s willing to live with worse inflation for longer than it previously did.

Some economists have noted the thin evidence upon which the Fed based its case for an improving economy. Instead of saying the economy is weak (as the recent Fed Beige Book did) the statement said it “continues to expand” in part because of “firming household spending.” But there have been only a couple of economic reports backing that up, and the better results may be related to the recent tax rebates. So, at best, the firming looks to be temporary. The Fed could find itself reversing that commentary in short order.

Here’s how I think about all this complexity: the Fed still firmly believes that inflation is going to come down because of the weak economy. But it’s prior forecast for that to happen didn’t materialize. So it’s looking to give the forecast a little more time to come to pass, talking tough on inflation but doing essentially nothing. If they don’t get help from lower energy and food prices — and tame core readings on inflation — by say, mid- to late-fall, then the Fed will abandon that forecast and you could see a forceful turn of policy toward hiking.

The oil market has another four or five months to cooperate with Bernanke and the Fed. After that, there will be a war and it could get ugly.