Fed Statement: Watch Out For Goldilocks' Three Bears

by: Markos Kaminis

Wednesday was a key day for interest rates and equity markets alike. We believe it marked an inflection point, from which expectations for a rate cut, turned toward a general market outlook for a rate hike in 2007.

The GDP report Wednesday morning started the day off on the right foot, but the news should not have surprised anyone. Estimates for the most important metric of economic health gradually rose during the month, from 2% on January 1st, to 3% recently, among experts measured by Bloomberg. Economists have increasingly gained confidence in the growth measure due to strong reports from leading economic indicators.

Fourth quarter GDP came in even stronger than anticipated, at 3.5% in the advanced report that will be adjusted as much as twice in the weeks to come. Growth was driven by the strength of the American consumer, despite a 19.2% drop in construction spending. However, prices increased 2.1%, and still measure above the Fed's target range of 1-2%.

As important as the GDP data was, the most important news of the day came from the Federal Reserve at 2:15 p.m., when the Board of Governors reported their decision on interest rates. The Fed kept interest rates steady, as was widely anticipated. Still, market participants were closely attuned to the official statement from the Federal Reserve for possible signs of the direction of their future actions.

In recent statements, the Fed has brought focus to its concern about inflation. With economic growth apparently sustainable despite housing weakness, we expect the Fed will now focus more on getting inflation down into its target range of 1-2%. So, you might understand our surprise when major financial media referred to the official statement from the Fed as "perfect." When reporters went so far as to label the economy "Goldilocks," we were forced to author this note.

From the official statement from the Fed:

Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time. However, the high level of resource utilization has the potential to sustain inflation pressures.

The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. (emphasis added)

As you can see, the Fed never mentioned the possibility of easing interest rates, while they explicitly noted the potential for a firming action. As we have noted in the past, we view food and energy pressures intense enough to drive overall inflation. Healthy economic growth and strong employment only add to the pressure.

We believe that between today and the release of the FOMC meeting minutes, in which we expect a hawkish tone to be revealed, the market should recognize the risk and correct. Still, we must note the accuracy of the Bernanke-run Fed to date, and take some solace in that. However, if the Fed were forced to act to stifle inflation, we expect investors buying into the Goldilocks theory would be eaten alive by the three bears.