Why Wall Street Loves the Fed's Subtle Shift


No surprise, the Federal Reserve left short-term rates unchanged today at 5.25 percent. But in its statement after the meeting, the Fed explicitly expressed way more concern about inflation than economic growth. The Fed's Open Market Committee described price pressures as "somewhat elevated." (In its January comment, by contrast, the FOMC said inflation had "improved modestly.") What's more, the Fed said that its predominant policy concern was inflation rather than growth; the latter it expects "to continue at a moderate pace."

Now oftentimes such language might have spooked investors since it would seem to increase the chances of more interest rate increases–and the chance that rates might get raised too high and cause a recession. As the Bear Stearns economic team put it this afternoon: "If the Fed's predominant policy concern is that inflation will fail to moderate, then the most likely risk to policy is higher rates relative to the current 5.25 percent funds rate, not lower rates. We do not see the changed language as paving the way or opening the door to a potential rate cut down the road."

But the Dow Jones industrial average quickly moved to a triple-digit gain on the news. Here's why:

1) The FOMC removed a reference to "the extent and timing of any additional firming that may be needed to address these risks," and instead concluded with the more neutral statement that "future policy adjustments will depend on the evolution of the outlook for both inflation and growth." Here is how economist Robert Brusca interpreted the change: "What we are left with is a bias statement that is less aggressive and less pointed." In other words, the Fed seems less likely to raise rates.

2) Wall Street of late hasn't been worried about a recession sometime, maybe in the future, but a recession in the here and now because of the imploding housing market. Just this afternoon I chatted with Hugh Moore, portfolio manager of the Guerite Absolute Return fund and a guy who used to run a subprime mortgage company in the late 1990s. He painted me a picture of how the tumbling housing market–still only two thirds the way to the bottom, as he sees things–will eventually kill consumer spending and lead to a recession. (That call ties into to his macromodel of economic and market indicators, which is also predicting a recession.)

So the fact that the Fed, which has some pretty fancy economic models of its own, continues to think the economy will expand was taken as a big plus by Wall Street. It's a "bad news is good news" sort of a thing.

Would Hillary preserve the capital gains tax cuts? The new Democratic federal budgets, both House and Senate, floating around Congress put the kibosh on the 2003 cap gains cuts due to expire at the end of 2010. But a veteran Washington insider E-mails me this: "Hillary Clinton visited Bear Stearns investors last week–and basically hinted that she would extend the cap gains/dividend relief, but allow the top income tax rate to rise."

My take: That would sure be an interesting development, but then again, politicians always seem a bit more investor-oriented when speaking to a Wall Street audience. The Nancy Pelosi-led House has put forward a budget that lets the 2003 cuts expire, for instance. Yet here is what Pelosi said last November on CNBC's Kudlow & Co. (which is kind enough to have me as a guest from time to time) after host Larry Kudlow asked here if raising cap gains taxes would be a first resort or a last resort. Pelosi responded:

"In my thinking, an earlier resort would be to look at the tax cuts at the high end. ... Some of the tax cuts at the high end I think have to be revisited long before you would revisit the dividend and the capital gains, because we want cap–we want growth in the markets, and you don't want to deter that."

Interesting side note from the Shareholders Corner blog: A recent selloff in the Japanese stock market is being blamed on that government's plan to a scuttle a 50 percent cut in its capital gains and dividend tax rate that was enacted back in 2002.

Around the blogosphere: 1) Barry Rithholz of the Big Picture spotlights one of my favorite megatrends, the gradual development of the Chinese consumer sector; 2) TaxProf Blog gives a great roundup of interesting–believe it!–tax news including efforts by the Internal Revenue Service to rebrand itself; 3) Harvard professor and former Bush economist Gregory Mankiw drills down into the fascinating debate over wage insurance.

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The Fed Charms Investors With Its Mixed Message