Relief that the seemingly interminable period of electoral chaos likely will finally be resolved with a Supreme Court decision favoring George W. Bush should continue providing a measure of short-term support for equities that have borne the brunt of this unprecedented political crisis. Conclusive defeat of Al Gore’s scorched-earth campaign for Florida’s 25 electoral votes would figure to boost market confidence enough to seed recovery of some portion of the NASDAQ’s losses since closing on November 7 at just above 3,400. That would, though, leave unaddressed the major obstacle to the markets still posed by the Fed’s deflationary policy stance. Should the FOMC next week follow-through in some concrete way on Alan Greenspan’s assurances that the central bank stands ready to act against “excessive softening,” chances are the hiatus of the secular bull market would be over. Judging from the atmospherics surrounding preparations for the December 19 FOMC meeting, however, the committee at this point appears unlikely to do anything more conclusive than issue a pro forma declaration that inflation and recession risks are now “in balance.” That suggests initiation of Fed rate cuts might still be put off until March, risking deeper economic deceleration and leaving equity prices vulnerable to further erosion.

Greenspan’s speech last week opening the door to eventual easing was immediately followed by a parade of Fed officials whose comments seemed intent on keeping expectations from moving ahead of the Fed’s willingness to act. That was reinforced by Friday’s employment report for November. While indicating a continued cooling of labor market conditions, with unemployment rising from 3.9% to 4%, it did not show the kind of deterioration that a significant segment of the FOMC apparently still requires to sanction a shift to an easing stance. Amid mounting evidence of the damage being done by the Fed’s monetary squeeze, near-term policy appears likely to remain captive to an estimate of prior-month labor market conditions that has no known relationship to changes in the relative strength of dollar purchasing power. Even taken on its own dubious terms, the unreliability of the jobs data as a contemporaneous policy indicator was vividly demonstrated by the revised October data reported Friday. Private sector payrolls, initially reported as being up by 117,000 jobs in October, were revised down to 74,000. Private payrolls in November, meanwhile, reportedly grew by 148,000.

The Fed’s Phillips-Curve alliance also undoubtedly noted the second consecutive month of 0.4% growth in hourly wages, moving the 12-month growth rate to 4%, highest in two years.  Fed Governor Ed Kelley must have had the dreaded specter of “wage inflation” in mind when he told Reuters Friday, "Inflation is creeping up. The movement is slow and sluggish and not terribly concerning at this point, but nevertheless up," he said. "My concern is that we stop that before it has an opportunity to gain any momentum." But, in an indication of the internal contradictions now bearing down on policymakers, he also added, “We are transitioning from a very high rate of growth to a lower one and we're going to have to watch very closely whether or not there's a possibility that we might overshoot to the downside, and that's a concern," he said. "We're going to have to be very alert to that possibility."

Indeed, initial jobless claims accelerated in the two weeks following the survey period last month, suggesting the December report is likely to show a further rise in joblessness. That will not come soon enough, however, to affect the committee’s deliberations next week. Still, there remains an outside chance that panelists professing an approach geared more to forward-looking market-based indicators of dollar strength could prevail on their colleagues at least to adopt an easing bias in the post-meeting announcement. For these FOMC members, such as Dallas Fed President Robert McTeer, the recent rally in long-term Treasuries, particularly the extent to which nominal yields closed the gap with their inflation-indexed counterparts (see chart), could figure prominently. Were the market at all uneasy about the potential inflation implications of forthcoming Fed ease, a bond rally driven solely by expectations of a falling fed funds rate would likely have been matched or exceeded by a decline in “real” inflation-protected yields. Instead, the rally that has knocked some
50 bps off the nominal 10-year note, to a yield around 5.35%, has seen a near-equal contraction of the nominal/inflation-indexed spread, from nearly 200 bps to about 150 bps.

TIPS Spread

Rather than opting for the insurance of inflation-indexed debt in anticipation of Fed easing, in other words, the market has been capturing the premium in nominal yields created by the Fed’s earlier hiking of short-term rates. This market behavior in itself confirms that rates were pushed to levels out of all proportion to virtually imperceptible inflation expectations. For any policymaker attuned to market-driven indicators, it is an unmistakable signal that the correct option is to cut rates.  Unless the bias is shifted to rate cuts at next week’s meeting, however, an easing bias will not be sanctioned until the late-January meeting, which under the Fed’s methodical approach would mean that the first rate cut could be delayed until the following session scheduled for March. That would further contribute to the ongoing slowdown in economic activity, as potential borrowers – knowing lower rates are on the way -- delay taking on new debt.