Markets flinch at a word from Fed

Slight language change in news release is seen as sign rates to rise soon

January 29, 2004|By Bill Atkinson | Bill Atkinson,SUN STAFF

The Federal Reserve Board voted yesterday to keep short-term interest rates unchanged, but it rocked the stock market by signaling that record low rates won't last forever.

The Fed's 12-member Federal Open Market Committee roiled the market when it subtly changed the language in a statement released yesterday afternoon after its two-day meeting.

Investors interpreted the move as a clear message that the Fed could soon raise interest rates.

The change caught economists and market strategists by surprise because they were certain the Fed would maintain its current language, which said that its "policy accommodation" on interest rates "can be maintained for a considerable period."

Instead, the Fed slightly changed the language, saying it "can be patient in removing its policy accommodation."

"This is almost totally unexpected," said James Paulsen, chief investment strategist at Wells Capital Management in Minneapolis. "Virtually no one I know expected them to do it."

The shift jolted investors, who sent the Dow Jones industrial average down 141.55 points, or 1.33 percent, to 10,468.37 in the last hour and 45 minutes of trading.

The Standard & Poor's 500 index fell 15.57 points, or 1.36 percent, to 1,128.48.

The Nasdaq composite index lost 38.67 points, or 1.83 percent, to 2,077.37.

Higher interest rates would cool off the nation's housing industry, a major driver in the recovery. They would also lead to higher borrowing costs for corporations and consumers, and they could reduce the nation's rate of economic growth.

But higher rates would also limit the potential danger of inflation, which would take the punch out of the recovery if it went unchecked.

Stephen L. Stanley, senior market economist at RBS Greenwich Capital in Greenwich, Conn., said the market overreacted.

"I think it was a knee-jerk reaction," Stanley said. "I'm not sure the Fed viewed this as an important substantive change; they may have seen it as a shift in semantics.

"I just think the markets were not prepared."

Most expect delay

Most economists don't expect the Fed to raise interest rates anytime soon because the economy is just starting to catch its balance after several lackluster years and weak job growth.

"They will wait as long as they can before they change the direction in policy," said Michael Englund, chief economist at Boulder, Colo.-based Action Economics LLC.

Federal Reserve Chairman Alan Greenspan "generally has been slow to shift direction. We have generally felt ... people generally jump the gun to guess when he is going to tighten or ease."

Englund expects the Fed to wait until midyear to raise interest rates.

Economy stronger

Most economists agree that at some point the Fed will have to raise interest rates, which are at 45-year lows, because the economy is gaining strength.

In the third quarter, gross domestic product, the value of goods and services produced in the United States, rose at a sizzling 8.2 percent annual rate, a full point above the 7.2 percent estimate a month ago.

In addition, corporate profits are strong, consumer confidence is rising and unemployment has fallen to 5.7 percent.

Robert B. MacIntosh, chief economist at Eaton Vance Management, a mutual fund company in Boston, said the Fed's statement gives it "more freedom, more latitude to be able to raise rates."

"I don't think this by any means is a forewarning of an imminent increase," he said. "They need to go ... toward a tightening bias. Right now they are just neutral. I think they are at least two meetings away from raising rates."

MacIntosh predicted the Fed will be careful not to do anything dramatic in an election year.

"I think he [Greenspan] doesn't want to be perceived as potentially sabotaging another Bush election," he said.

"They are supposed to be independent. I think he will do all he can do not to get tagged with that."

Avoiding volatility

Greenspan was criticized for hurting George H.W. Bush's re-election chances in 1992 after the Fed raised interest rates.

"They don't want to be a source of volatility for the markets," Stanley said. "You can be sure that they are trying to figure out how to get out of the way."

Experts see the economy growing at a 4 percent-to-5 percent annual clip this year, fueled in part by low interest rates and the Bush administration's tax cuts.

"I think the best guess is the economy is going to continue to perform well," Englund said. "You'd be hard-pressed to find a time where underlying economic fundamentals have been this positive."

Englund expects the economy to expand for the next five to eight years.

"There is little reason to foresee any negative developments for the next couple of years," he said.

Weakness in jobs

Despite the economy's progress, few jobs have been created. Only 1,000 new jobs were added to payrolls last month and more than 2 million jobs have been lost since the current President Bush took office.

But economists said companies are hiring and the numbers will show up soon.

"The December payroll number is going to prove to be an aberration," Stanley said. "I think we are already seeing an improvement in the job market."

Jobs will be key to Bush winning a second term in office, experts said.

"I think it is extremely important," MacIntosh said. "Bush needs to see that the economy is recovering nicely and that jobs are coming about as a result.

"People don't care if you have 8.2 percent growth; what they care about is jobs."

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