Monday, June 27, 2005

The Fed Plays the Expectations Game

In a previous post I pointed out that the Fed under Greenspan’s direction has tried to be as predictable as possible. This observation can be useful in surprising ways.

This past weekend views on likely Fed policy have started to crystallize. Bill Gross, PIMCO’s founder, is an opinion leader in the bond market. He is quoted in this week’s Barron’s Current Yield column as saying that the Fed will raise the funds rate another 50 basis points to 3.50% and then start to lower rates later this year. (Funds currently trade at 3.00% and the Fed is widely expected to push this up to 3.25% this week.) Other commentators are starting to join this chorus as this week's cover story in Barron's also suggests.

I think this means that the bond market’s expectation is moving in the direction of a Fed mid-year pause in its moves towards higher rates. Moreover, the sideways action of the stock market during the past 18 months certainly will cause the Fed some worry about the strength of the economic recovery and thus encourage such a pause.

Since the market’s expectation of a mid-year Fed pause is growing, such a pause is becoming more and more likely. After all, the Fed wants to be predictable and I conclude from this that it is encouraging this change in expectation.

Finally, I should point out that my 2005 bond market forecast predicted just such a pause (starting in May 2005) base solely on George Lindsay inspired analysis of time periods between major interest rate extremes.

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