Careless communication and wrong signals

Minutes of the March meeting of the US Federal Reserve Open Market Committee (FOMC) were released on March 18. In the last paragraph, members of the FOMC had twice said they had just about reached the end of the process of raising short-term interest rates that began in June 2004. In fact, they had expressed concern that their communication at the end of the meeting held in March should not convey the wrong impression that the Federal Reserve had several tightening steps in mind after March.

Clearly, they were about to pat themselves on the back for a job well done and walk off the tightening table. The communication is disappointing and even somewhat unprofessional, for two reasons.

One, there is no reason given as to why they thought their job of tightening was almost over. What were the factors that they looked at, to conclude that they should end the sequence of rate hikes? We are left in the dark. Mind you, they did not even use the word ?pause?, but they used the phrase, ?…end of the tightening process was likely to be near.?

Further, it is somewhat amusing to note that the thought about ending the tightening cycle follows the sentence on the economy operating near potential and aggregate demand remaining strong.

The second disappointment comes from the fact that the FOMC had not contemplated the possibility that the very mention of the likely end to rate increases could stoke such a frenzy in asset prices, feeding through to aggregate demand, thus renewing the need for further rate hikes. That is what happened. The CARRY trade and further bubble-like gains in emerging market assets have been activated by, what appears to be, a premature open contemplation of an end to the rate hike campaign. For example, the Indian stock market is in a state of delirium.

Admittedly, it is difficult, if not impossible, for the Federal Reserve to signal that they are mindful of the risks of over-tightening without stoking the financial market?s enthusiasm for risky assets at current elevated levels of valuation.

In the press release that accompanied the meeting in January, the Federal Reserve had shown some transparency by focusing on resource utilisation as their guiding principle. In practical terms, it refers to the unemployment rate.

Let?s see (table) where demand and price variables are at end-March 2006 compared to June 2004, when the Fed began raising the Federal funds rate from 1%.

The economy has continued to chug and has even accelerated since the Fed began tightening. In fact, with the real federal funds rate (nominal deflated by the annual headline CPI inflation rate) well below historical norms, it can be safely said that the Federal Reserve has accommodated the run-up in energy prices.

Let us also see what the FOMC thought on consumption spending going forward:

?In coming quarters, consumer outlays were expected to be supported by continued employment gains, household income growth, and relatively low long-term interest rates, even if gains in housing wealth abated.?

So, in the final analysis, the flow of data is likely to shake the Fed off its complacency and cause the Federal funds rate to be pushed up to 5.5% during the year.

Meanwhile, of course, the release of the minutes has added fuel to the euphoria on hard and precious metals. The rally has been so unreal that even die-hard commodity optimists advocate exiting and standing on the sidelines. Of course, no one can predict when this mindless bull-run would end but let us be very clear: when they end, they end in tears.

When bubbles are small and they bust, they do not leave a mess. When they get bigger and then they bust, they leave a big mess. We are getting into that now. To an extent, the Federal Reserve has to take the blame with its somewhat carelessly worded minutes of the March meeting.

?The writer is the founder-director of Libran Asset Management (Pte) Ltd, Singapore. These are his personal views