May 2007

A Little Too Cloudy!

By Brad C. Stewart, Vice President/Chief Investment Officer

Last month I ended my FYI with the hope that April would be a good month. If my desire had been for the eastern seaboard to become drenched in an unending supply of rain, then my wishes would have come true. As far as the weather is concerned, April hasn't exactly been the kind of month I was expecting.

How about the economy? The statement made, following the conclusion of the March 21 Federal Open Market Committee (FOMC) meeting, once again affirmed that the Committee was leaving the overnight rate unchanged at 5.25 percent. Sounds kind of boring, right?

Hold on there, not so fast! It wasn't what the statement said as much as what it did not say that got the markets all worked up. It did not suggest that the next move would be a tightening, as it had in previous statements. As far as the markets were concerned, this statement was "a little too cloudy." The markets immediately read into these omissions that the next move by the Federal Reserve was not going to be an increase in the overnight rate. They also concluded that it would only be a matter of time before the Fed would begin to lower the overnight rate.

Don't forget that unlike his predecessor, Chairman Bernanke's stated goal, with regards to the Fed's monetary policy statements, was to be as transparent and clear as possible. Because this goal was obviously not achieved, several Federal Reserve officials wasted no time in coming out and disputing the markets' conclusion. In speeches around the country they made it perfectly clear that inflation continues to remain their number one concern. They are aware of the economy's current issues, primarily due to the housing situation, but continue to believe it will remain strong.

As is now customary, the minutes were released three weeks after the meeting was held. The decision to change the wording was not a signal that the FOMC was going to a neutral bias. It was the recognition that future monetary policy, while still very much concerned about inflation, might be influenced by economic conditions and they wanted to have the ability to react accordingly.

They have reached the point we have discussed in earlier FYIs; that the FOMC's crystal ball is no clearer than yours or mine. They believe, from their analysis, that the economy in 2007 will continue to prosper and the bursting of the housing bubble will not require a reduction in the overnight rate. When the overnight rate was in the range of 1.0 to 4.0 percent, they knew they had to raise the overnight rate. Now that the rate is at 5.25 percent, future decisions require more economic statistics to verify their thinking.

This debate goes on everyday as to what conclusion can be drawn from the next announcement of the latest economic statistic. The Fed, along with some Wall Street economists, believes one thing, while other economists on Wall Street believe another. This is what constitutes a market, buyers and sellers. Meanwhile, assuming no defining economic statistic, the overnight rate will remain at 5.25 percent.