Monday, 24 April 2006

Fed rate hikes: The end is near . . . maybe

The widely-accepted view in market circles is that stocks perform poorly in an environment of rising interest rates. So it comes as no surprise that recent indications that the Federal Reserve may be nearing an end to its rate-hiking campaign has provided a boost to US as well as global stock markets.

According to the minutes of a Federal Reserve meeting on 27-28 March, policy-makers indicated that the US central bank could be nearly done raising interest rates. "Most members thought the end of the tightening process was likely to be near, and some expressed concerns about the dangers of tightening too much, given the lags in the effects of policy," said the minutes.

Prices of stocks and bonds rose on 18 April, the day the minutes were released. By the end of the week, the Dow Jones Industrial Average was at 11,347.45, up 1.9 percent for the week and less than 4 percent from its all-time high of 11,750.28 reached on 14 January 2000.

The impact was felt in stock markets in other countries as well. Japan's Nikkei 225 closed the week at 17,403.96, rising 1.0 percent over the week, while the FTSE 100 did even better, rising 1.7 percent over the week to close at 6,132.70, its highest close since February 2001.

Of course, the statement in no way guarantees that yields will not rise further. In fact, they do not even guarantee that the Federal Reserve will not continue hiking the federal funds rate.

"The need for further policy firming would be determined by the implications of incoming information for future activity and inflation," the minutes said. In other words, the future direction of Federal Reserve action is not cast in stone and will depend on incoming data. Indeed, the minutes also said: "With energy prices remaining high, prices of some other commodities continuing to rise, the risk of at least a temporary impact on core inflation remained a concern."

The implication of these statements was made clear on the very day after the minutes were released. On 19 April, core consumer prices were reported to have increased 0.3 percent in March, the fastest rate in a year. Bond prices duly fell, giving up their gains from the previous day.

Clearly, any data that justifies a change in current projections -- on the rate of inflation or economic growth -- would also change the course of Federal Reserve action.

Nevertheless, the significance of the Federal Reserve statements lies in the fact that it shows that the central bank is comfortable with current projections on inflation and economic activity, that it is not particularly hawkish on inflation, that it is mindful of policy lags, and that it does not want to risk triggering a recession.

That should be good news to stock investors, or more specifically, for the outlook for stocks over the next year or so. They still need to worry that the real economy might spring a surprise on them, but at least they do not have to worry so much that the Federal Reserve would.

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