The Fed has its own March Madness
Bernanke & Co. are seen holding steady, but will the Fed note the subprime mortgage mess, and hint at a future rate cut?
NEW YORK (CNNMoney.com) -- Former Federal Reserve Chairman Alan Greenspan has been in the news a lot lately. So it's only fitting to use one of the Maestro's more memorable expressions to describe the situation that the current Fed finds itself in: a "conundrum."
When the Fed's policymakers wrap up a two-day meeting Wednesday, they're widely expected to keep the federal funds rate, a key short-term rate that influences rates on consumer and corporate loans, at 5.25 percent for the sixth consecutive meeting.
Investors, however, are more concerned about what Fed Chairman Ben Bernanke and his colleagues will do for the remainder of the year. Just a few weeks ago, the consensus was that the central bank would leave interest rates at 5.25 percent for the remainder of the year.
That was before the subprime mortgage market imploded, leading to stomach-churning volatility in the stock market - and fears that more weakness in housing, and tighter credit in general, would hurt the broader economy, and possibly even spark a recession. Greenspan has made recent comments about the risk of subprime woes spreading to other areas of the economy and warned late last month about the possibility of a recession by the end of the year.
What's more, retail sales rose just 0.1 percent in February, a possible sign that the consumer may finally be feeling a pinch after the Fed's 17 consecutive rate hikes from June 2004 through June of last year.
Now, according to futures contracts on the Chicago Board of Trade, investors are betting on a strong likelihood of a rate cut by the summer and another one by year's end, which would leave the fed funds rate at 4.75 percent.
"The Fed could cut rates anywhere between a quarter of a percentage point and a half of a point later this year," said Matthew Smith, president and chief investment officer with Smith Affiliated Capital, an investment advisory firm based in New York. "The problems in subprime are like the hidden cockroach theory. You don't know how deep and how massive this will get until more companies start spilling red ink."
But here's the conundrum. Inflation isn't going away.
A surprisingly strong jump in wholesale prices last month, and a slightly higher-than-expected-rise in consumer prices, are proof to some Fed watchers that inflation remains a threat that needs to be kept in check.
In addition, hourly wages grew at a higher-than-anticipated rate in February - and rising wages are considered the biggest contributing factor to inflation pressures.
Therefore, despite mounting evidence of a possible economic slowdown and the turmoil on Wall Street, the Fed may have no choice but to hold rates steady for the foreseeable future - or perhaps even raise rates again, some economists argue.
"Look at the inflation numbers and wage numbers. The Fed may have to hit this one more time down the road with another rate hike," said Scott Martin, managing director of investments with Astor Asset Management, a money management firm based in Chicago.
Forget about the NCAA Tournament. This is your real March Madness.
With all this in mind, investors will probably be paying even more attention than usual to what the Fed says in its statement about the economic outlook. For the past few meetings, the central bank maintained that growth is "likely to expand at a moderate pace" and that "some inflation risks remain."
Some think that language may have to change in light of the worries about the possibility of mortgage defaults continuing to rise, which could further dampen consumer spending.
"The economy is clearly weakening now and a lot depends on the housing market," said Michael Pietronico, a municipal bond portfolio manager with Evergreen Investments. "This meeting will be the most interesting Fed meeting in the past three or four meetings. It's hard to imagine the Fed just talking about inflation. They should acknowledge that the risks of the economy slowing are greater than they had been."
But some analysts say the Fed may not want to tip its hand about its future intentions just yet since it's too soon to say how serious the problems from the subprime mortgage market will be.
Steven Bleiberg, head of global asset allocation for Legg Mason, said the Fed may want to let the mortgage problems sort themselves out. With interest rates still at relatively low levels, he thinks the last thing the central bank wants to do is lower rates further and cause the housing market to heat up again.
"The Fed may throw something in the statement to people to indicate that they are paying attention to the mortgage market and not ignoring it," Bleiberg said. "But they are conscious of the criticism that, by cutting rates as aggressively as they did six years ago and keeping rates as low as they did for as long as they did, they created the situation for easy financing which caused this problem in the mortgage market."
In the wake of the tech bubble's bursting in 2000, a recession and the Sept. 11 terrorist attacks, the Fed slashed rates from 6.5 percent at the start of 2001 to 1.75 percent by the end of the year. The Fed cut rates once more in 2002 and again in 2003 to bring them to 1 percent and left them there until June 2004.
But several Fed watchers said they think the biggest difference between the Bernanke-led Fed and Greenspan's Fed is that Bernanke is probably not paying as much attention to the financial markets as his predecessor. So don't expect the Fed to change its tune just because of the twists and turns on Wall Street.
"A 400-point drop in the Dow is not going to get this Fed nervous," said Evergreen's Pietronico, who describes Bernanke as more "inflation-phobic" than Greenspan. Astor's Martin agrees. He thinks that Bernanke is more interested in hard-core economic data and less with market psychology.
"I really think the Fed is not watching the stock market. I'd like to think that with all the volatility they are viewing it more as emotionally driven trading as opposed to an actual economic crisis," said Martin.
So investors hoping for the Fed to signal that it's ready to start cutting rates several times this year might be disappointed.
"My instinct is the Fed is going to more or less leave things alone in its statement," said David Joy, chief market strategist for RiverSource Investments. "The Fed's primary concern is still going to be inflation. There is weakness in housing but beyond that, the Fed probably doesn't think the economy has changed."
As such, Joy thinks the Fed might cut rates once later this year, and then might start raising them again.