Views from the Frontline: What is the Fed's next move?

Submitted by Craig Strzelecki on 15 December, 2005 - 09:06

The United States Federal Reserve has delivered on market expectations by raising its benchmark interest rate by another quarter percentage point to 4.25 per cent and signalling more to come.

However, a change in wording in the statement - the removal of the description of policy being 'accommodative' in favour of 'some further measured policy firming is likely" - was taken as a signal that the end of the cycle is nigh. Bond yields fell slightly in response, the US dollar lost some modest ground and equity markets rallied.

This was the Fed's 13th consecutive rate rise in a tightening cycle that began in mid-2004. At that point, the funds target rate was at a four-decade low of 1.0 per cent.

Here is a sample of views from market economists and strategists on the Fed's statement and what might happen next:


"On average, short rates have never been lower than seen two years ago. unrestricted. This loose monetary policy stimulated economic recovery, as well as a boom in asset prices. So the first, and perhaps most important point, from the turn in rates is that it should slowly bring the curtain down on the liquidity flows that have supported asset prices. The small-picture point of interest is how much more tightening is likely. By dropping the reference to accommodation in the accompanying statement, the FOMC did no more than state the obvious. One per cent cash rates are loose; 4 per cent-plus are not. What also seems obvious is that future moves will be more data-dependent. Historically, what stops the Fed tightening is fairly clear: sharp declines in leading indicators, or a weaker labour market. My bet is that the optimistic Fed-tightening-is-near-an-end reaction of markets overnight will be a little premature."


"My US colleagues believe that signs of above trend growth and rising core inflation will keep the Fed on track to raise rates to 5.0 per cent by May, 2006. The fact that policy is no longer explicitly referred to as accommodative is not particularly meaningful. What matters is whether policy settings are thought to be appropriate and on that score the message from the Fed seems loud and clear. The economic expansion is said to be 'solid'. And whilst the Fed is comforted by recent low readings for core inflation and by measures of longer- term inflation expectations, it is well aware of possible upside risks from elevated energy prices and possible increases in resource utilisation. The latter risk explicitly recognises that the economy is now operating close to trend. So further tightening seems likely if the dataflow remains robust."


"With the market already knowing that the Fed was discussing the need to introduce more flexibility into their statement language at the November meeting, dropping the word 'accommodative' did not cause any seismic shift in market pricing for future rate rises. The next meeting is at the end of January -Greenspan's last and a rise at that meeting continues to be not quite fully priced, pretty much where the market was yesterday. What this morning's statement does is hammer home the absolute data dependence of US monetary policy form here on in rather than any robotic series of hikes. While the Fed has formally shied away from nominating what a neutral rate might be, using the yardstick of an average short term real rate and inflation gives a neutral rate in the 4s, pretty much were we think the funds rate is and where it will get to when the Fed likely tightens again at the end of January."


"By changing the statement, the Fed has made an important step in its exit strategy but it does not appear to have signalled a significant change in bias. The Fed's removal of the reference to 'accommodation' suggests it considers the funds rate to be close to neutral. The implication is that it does not have to raise rates significantly far from current levels. But while the Fed has signalled that some further policy firming is likely, it has also allowed itself flexibility should the data suggest that an alternative course of action is required. "