Three weeks after the Fed’s unexpected shift into easing mode gave rise to a growing sense that a sustained reversal of the earlier rate-hiking cycle was at hand, that optimism was bound to be subject to second guessing at some point. We noted earlier that restoration of a degree of market confidence could itself provide a rationale for a less aggressive approach among some policymakers (“Tentative Signs of Life,” January 12, 2001). A published report hinting that this indeed was among the factors being weighed by certain unnamed Fed “officials” in advance of next week’s FOMC meeting spurred a bout of intense hand wringing in short-term credit markets yesterday. In the larger scheme of things, though, the consternation this caused seemed somewhat over done. In the fed funds futures market, odds that next week’s meeting will enact another double-dip 50 basis point cut – rather than the customary 25 – dropped back to almost a sure thing (86% chance) from very nearly a sure thing (94% chance).

Alan Greenspan’s testimony tomorrow to the Senate Budget Committee is being eagerly anticipated for guidance on this point, but it’s questionable whether he will provide much satisfaction on such a relatively narrow issue of policy implementation. Still, Greenspan is likely to convey a sense of significant concern that should continue to support expectations for an extended funds-rate rollback. The betting here is also that in the current risk environment, it’s unlikely that Greenspan wants to hazard the consequences of upsetting market sentiment. If the market is priced for another 50 bp cut next week, he will be strongly inclined to deliver it.   

Although one or another nameless Fed personage might offer a stray comment questioning the scope for additional action, Greenspan is believed to hold a considerably less sanguine view. He has done nothing to attempt to alter the perception that the January 3 move was essentially a unilateral decision on his part, motivated by a strong sense of urgency over the deteriorating economic and financial climate. If this were in any way contrary to his current views, we can be sure that he would have found a way to convey it through his usual off-the-record channels. Greenspan, of course, is not the only central banker that was caught off guard by mounting evidence of the economy’s nosedive late last year, and the financial fragilities that it exposed. Richmond Fed President Alfred Broaddus, an unabashed supporter of the 175 bps in growth-squelching rate hikes in 1999-2000, must have undergone a head-spinning realization that even as the FOMC was warning of the continued threat of rising excess demand, the economy was braking sharply. Citing the Fed’s surprise 50 bps inter-meeting move this month, Broaddus told one group, “the Fed is alert and well aware of the turn in household and business sentiment in recent weeks, and is prepared to act decisively to help keep the economy from softening excessively.”

No doubt, factions among the FOMC and senior Fed staff are suspiciously eyeing the market’s recent performance – particularly in higher-risk debt and equity segments – convinced that further significant easing will sow the seeds of another market “bubble.” There have indeed been signs of a welcome recovery in the availability of risk capital the past three weeks. The high-yield bond market, decimated last year by the Fed’s real-interest-rate squeeze, has come roaring back to life, with more than $7 billion in new issues since Jan. 1, compared to just $4 billion for all of last year’s fourth quarter. The KDP Investment Advisors High-yield Total-return Index is up more than 5% since the rate cut, and more than 8% from early last month, when the index sat only marginally above its lows in the 1990-91 junk-bond rout. Among the more market-savvy figures at the central bank – among whom we would list Greenspan – such performance is likely seen not so much as affirmation for the one rate cut sanctioned thus far, but as a response to the expectations of more extensive action yet to come. An uprooting of these expectations likely would also precipitate a significant reversal of recent gains.

One potential source of concern that cannot as easily be dismissed, however, is the recent sharp steepening of the yield curve, with the 30-year bond – at about 5.65% -- up some 30 basis points from its levels just prior to the Jan. 3 move. In one sense, this yield back-up can be interpreted positively, as it suggests an unwinding of the deflation trade that was drawn to capture the rising expected real returns made available by an ever-appreciating unit of account. There’s no question, though, that the long-bond sell-off is also a reminder of the risks inherent in the Fed’s highly sub-optimal approach to fine-tuning real economic outcomes. Correcting a deflationary policy error with an inflationary one, of course, would provide no net benefit to economic well-being. That said, it is also noteworthy that at about $265 per ounce, the price of gold has as yet shown no reflationary impulse, much less one that would suggest a real risk of incipient inflation. Rather than discounting an expected decline in the dollar’s purchasing power, then, the pop in long-term yields likely reflects a normal risk premium that can be expected to appear during a period when the Fed is perceived as likely to ease aggressively. That also suggests that as the market becomes persuaded that the Fed is not likely to lurch into inflationary overkill, yields are likely to move lower again.