Saying Little Could Be Fed’s Best Move

Federal Reserve policymakers today might be wise to take a step back in history, to a time when central bankers were men of relatively few words.

At least, that’s what many economists and bond traders are advising after being whipsawed by seemingly conflicting Fed statements over the last three months.

Chairman Alan Greenspan and his peers, meeting today, are expected to leave their benchmark short-term interest rate unchanged at 1%.

Beyond that, many analysts say the Fed would be justified in merely repeating its official position from the June meeting: that the odds of a sustainable pickup in the economy are about the same as the odds of renewed weakness, and that the risk of deflation is greater than the risk of inflation.

Though recent data have been pointing to a stronger economy, the Fed can’t sound too upbeat without triggering another sell-off in the bond market that would drive longer-term interest rates up further, experts said.

Bond yields have surged since mid-June and rose again Monday ahead of the Fed’s meeting.

But neither can the central bank risk sounding too pessimistic about the economy, because that could hammer stock prices, which rallied sharply in the spring and have mostly been treading water since.

Walking that knife edge, the Fed should simply opt to emphasize that it will stand pat for the foreseeable future -- and say it “in as few words as possible,” said Robert Podorefsky, chief interest rate strategist at FleetBoston Financial.

By limiting its official statement, the Fed would give nervous bond investors less verbiage to pore over and thus less to potentially misinterpret.

The bond market has been in upheaval since mid-May, when Greenspan and other Fed officials hinted that they were concerned enough about the risk of deflation -- a broad decline in prices throughout the economy -- to warrant the possibility of extraordinary policy moves to boost business and consumer spending.

One of those moves, officials said, could be for the central bank to buy Treasury bonds in the marketplace, to push long-term interest rates lower.

That possibility helped fuel a buying frenzy in the Treasury bond market from mid-May to mid-June, pushing the 10-year T-note yield to a generational low of 3.11% by June 13.

When the Fed met in late June, however, it sounded less worried about the economy. That also was evident from its decision to cut its benchmark short-term rate, the so-called federal funds rate (the rate banks charge one another for overnight loans), by a quarter-point on June 25 instead of the half-point many bond investors had expected.

Then, in mid-July, Greenspan suggested in testimony before Congress that the Fed believed there was little chance it would find it necessary to buy bonds.

Combined with stronger economic data, the Fed’s seeming about-face encouraged many traders and investors to flee bonds, fearing that yields could continue to rise.

The result: The 10-year T-note yield has rocketed, and stood at 4.35% Monday, near a one-year high.

Some analysts say bond traders have no one but themselves to blame for the market’s wild moves in recent months.

Even so, many bond market pros say the Fed appeared to conclude that direct intervention in the market was too dangerous to contemplate.

“I think they saw that ... you can get in, but how do you get out” when it’s time to sell bonds, said Robert Lunder, global head of government bonds at Bear Stearns & Co. in New York.

The Fed isn’t expected to revisit the subject in today’s official statement.

If Greenspan and his peers want to calm the bond market, their best shot would be to show they mean business about keeping short-term interest rates anchored at 45-year lows into 2004, even if the economy continues to revive, analysts say.

Investors recently have become more concerned that the Fed might begin to tighten credit as early as the first quarter of next year: Federal-funds futures contracts, which allow investors to speculate on the level of that rate down the road, now are pricing in a quarter-point increase by April.

But the Fed may not have good cause to raise short-term rates even by then, some economists say.

Podorefsky believes that the economy, at the moment, is benefiting from pent-up demand that was subdued early in the year by fears about the war in Iraq. Despite some recent upbeat economic data, however, “it’s difficult to say there’s a sustainable trend,” he said.

Moreover, deflation remains a risk, some analysts say.

The Institute for Supply Management’s survey of the U.S. services sector in July showed that although business activity jumped from June, an index measuring prices paid by service firms declined and was well below the levels of the first quarter.

That indicates that many companies “have near-zero pricing power,” which means the deflation threat is real, said David Rosenberg, an economist at Merrill Lynch & Co. in New York.

In theory, at least, if the Fed keeps its key rate at 1%, and inflation stays low, that should keep long-term bond yields from rising dramatically from current levels.

As bond yields edge up, big investors such as banks should find it enticing enough to borrow at rock-bottom rates and buy bonds, earning the “spread” between the 1% short-term rate and bond yields of 3% or better.

“That’s the brake on bonds selling off” further, said Lunder -- assuming the Fed can convince investors that short-term rates will stay depressed well into 2004.