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Wednesday, August 09, 2006

Reflecting on Market & Fed Actions

By Yaser Anwar, CSC of Equity Investmetn Ideas

The market was a bit surprised by the lack of inflation comments out of the Fed, especially in light of members having been running around lately saying they were concerned about price pressures, that things were on the high end of their "comfort zones." The market will be looking to the minutes for a more intimate look at what policy-makers are looking for.

Yet by pausing now, Fed officials may be risking even higher inflation if their forecast is wrong. The Fed's preferred price gauge, which excludes food and energy costs, increased 2.4 percent in June from a year earlier, the fastest clip since September 2002. Bernanke and other officials have said they're comfortable with inflation between 1 percent and 2 percent.

Investors should keep in mind the Fed’s failed attempt to battle inflation in '94. By calling an end to the rate hiking cycle in August, that the rate hikes up to that point were “expected to be sufficient at least for a time to meet the objective of sustained non inflationary growth” only to realize how wrong this assessment was. And thus trying to play catch up, hiked rates 75 bp in November, leading to a rise of 100 bp in the 2-year yield within 3 months & nearly sending the economy into recession in '95.

Click here to see a table outlining the performance of the S&P 4Qs after a concluding tightening cycle (even though they aren't totally done yet.)

The unchanged policy rate and the less hawkish tone on inflation in the policy statement than expected, left the funds futures market pricing in stronger odds that the Fed remains on the sidelines. The implied policy rates now peak at 5.34% in November showing a 36% probability for another hike at either the September or October policy meetings.

However, with one Fed president dissenting in favor of a hike, accelerated core inflation in recent months and today's report of far stronger unit labor costs, i still see a potential for another rate hike by year end.

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