What the Fed Isn't Saying (7/07)

On June 28, the Federal Reserve maintained its target for the federal funds rate at 5.25%, the same "paused" level since August of 2006. With core inflation having stabilized at 1.9%, just below the Fed’s stated 1% to 2% comfort zone, even as non-core energy and food prices have remained stubbornly high, widespread speculation has surfaced that the Fed may be on the verge of changing its focus away from core inflation to overall or "headline" inflation which includes energy and food. Both the Washington Post and Financial Times recently reported on such a possibility, while several regional Presidents of the Federal Reserve seemed to validate the notion of a possible shift within the Fed.

In an early June speech, Cleveland Fed President Sandra Pianalto stated that "the reality of rising oil and commodity prices is evident, and my Federal Reserve colleagues and I have been clear that we believe the impact of these influences will dissipate over time. But until our beliefs are validated by the data, there is risk that the public’s trust could erode and inflation expectations could move higher". Offering an even bolder view, Dallas Fed President Richard Fisher told the Wall Street Journal that "both food and energy have had a steep upward tilt for the last three years in a row. Under these circumstances, I’m personally reluctant to put complete faith in the core measures because they may be removing more signal than noise".

Despite the speculation of an imminent and more hard-line policy shift, the statement that accompanied the Fed’s June 29 decision seemed dovish at first blush as the Fed’s reference to inflation as being "somewhat elevated" was eliminated. In its place, the Fed stated that "readings on core inflation have improved modestly in recent months". However, the Fed also added that "a sustained moderation in inflation pressures has yet to be convincingly demonstrated" and "the high level of resource utilization has the potential to sustain those pressures". While removing "elevated" from its description implies that the Fed has grown more comfortable with recent readings on inflation, the Fed statement also left out other key indicators for inflation expectations that may be telling a different story.

Specifically, gone is the reference to the likelihood that "inflation pressures ought to moderate over time". Additionally, there is no reference to inflation expectations "remaining well contained". These forward-looking statements had been hallmarks of the Fed’s pause-affirming language for the last year. The possibility certainly exists that, by removing references to "moderation over time" and "well contained inflation expectations", the Fed is actually more, not less concerned about future readings on inflation and inflation expectations, even as current readings of core inflation recede from a previously "elevated’ state. Perhaps what the Fed has omitted and isn’t saying in its policy statement is as important as what they did say.

The move in Treasury bond yields from below 4.7% to over 5.1% over the last two months signals that the U.S. economy is rebounding from the first quarter’s dismal .7% GDP growth rate and that a Fed rate cut is off the table. Consensus estimates for second quarter and third quarter GDP now stand at 2.5% and 2.8% respectively. Recent strength in the ISM manufacturing (14 month high) and ISM service (12 month high) indices, as well as June’s employment report that saw a better-than-expected 132,000 new jobs, support the case that economic growth is picking up. With the unemployment rate standing still at 4.5% and the price of oil back over $70 per barrel, the potential for mounting inflationary pressures will bear watching. Ironically and perhaps intentionally, should such inflationary pressures emerge, the Fed could actually be in a position of having "told us so" by what was left out and so "not told" in the recent policy statement.

The rising price of oil and tight labor market is leading some to suggest that a potential rate hike is back in play. Offsetting what we view as very slight odds for a Fed rate hike, the housing market and subprime mortgage mess show no imminent signs of recovery. In fact, with approximately $900 billion of subprime adjustable mortgages resetting in the next two years, any Fed hike could be disastrous for the already weak housing market. And with two Bear Stearns hedge funds tied to risky mortgage loans having recently imploded, fear of contagion in the financial sector should also help keep the Fed at bay. Our base case forecast for the Fed to do nothing through at least the rest of this year remains on track.

With GDP growth estimates on the rise, analysts are also ratcheting up their second quarter earnings estimates. First quarter consensus estimates at 3% were easily surpassed with actual earnings growth at 9%. Consensus for the second quarter is for 5% earnings growth, a figure we expect the market to again handily outpace.

Finally, we can’t help but find a touch of irony in the recent slew of IPO announcements by private equity firms. Following the recent splash in the public markets by Blackstone are private equity pioneer Kohlberg Kravis Roberts & Co. (KKR) and hedge fund-private equity giant Och-Ziff Capital Management. While we are reluctant to call a "top" in the private equity boom due to the still-low level of interest rates and relatively attractive valuation of equities, we sense that something just isn’t right in a world where private equity goes public as record amounts of public equity goes private. The gap between low interest rates and attractive equity valuations would seemingly have to close (either by rising interest rates or rising equity valuations) before the private equity window were to close. With the Fed likely to stand pat for the foreseeable future and with reasonable equity valuations even as GDP growth reaccelerates, our bet is for a rising stock market to eventually reduce the margin of safety for private equity.