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For Those Handicapping the Future a Fed ‘Pause’ Won’t Be End of Story

Times Staff Writer

Global stock markets have had a great run this year, better than what many investors might have hoped for.

And part of that run has been based on expectations that the Federal Reserve was nearly done with the credit-tightening campaign it began in June 2004.

If the Fed would get out of the way, there would be one less thing for Wall Street to worry about. And a big thing, at that.

But “nearly done” has come to mean different things to different people. One more quarter-point interest rate hike? Two more? Three more? One more, then a pause, then maybe another hike in a couple of months -- or a pause, then a rate cut?

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The possibilities aren’t exactly endless, but the debate has seemed so this year.

Most economists are certain that when Fed policymakers meet Wednesday, the central bank’s benchmark short-term rate will be raised to 5% from the current 4.75%. The only question is what Chairman Ben S. Bernanke and his colleagues will say in their official statement.

Or is it a question, really? It’s hard to imagine the Fed diverging much from what Bernanke told Congress on April 27: “At some point in the future, the [Fed] may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook.”

That may have been clearer than any comment Bernanke’s predecessor, Alan Greenspan, made in his 18 years at the Fed’s helm.

The party line from Bernanke and other Fed officials in recent months has been that the economy’s strength or weakness, and the trend in inflation, would determine what would happen with short-term interest rates. That seems reasonable enough.

Assuming the key rate goes to 5% this week, the Fed will have raised that rate 4 percentage points since mid-2004. That’s a lot, which is why it’s also reasonable to imagine policymakers wanting to pause. They know, as does Wall Street, that rate changes work with a lag: The effect on the economy shows up six to 12 months later.

Friday’s government report on April employment trends seemed to cheer every investor who had been entrenched in the “pause” camp.

The economy created a net 138,000 jobs last month, the smallest increase in six months. And the February and March job-growth totals were revised lower.

Although wages rose sharply -- average weekly earnings for nonsupervisory workers jumped 0.8%, the strongest gain since August 1997 -- some analysts said that shouldn’t stoke the Fed’s inherent inflation paranoia.

“If job creation keeps slowing, then wage pressure will simmer down,” said Anthony Chan, chief economist at JPMorgan Private Client Services in New York. He expects the economy to decelerate in the second half of the year, consistent with the Fed-on-hold scenario.

There are dissenting opinions, but financial markets weren’t listening to those Friday. Share prices surged, pushing the Dow Jones industrial average up 138.88 points, or 1.2%, to a six-year high of 11,577.74. That left the index a mere 1.3% from its all-time high set in January 2000.

In the Treasury bond market, where yields had been climbing sharply since late January, the 10-year T-note yield edged down to 5.09% from the four-year high of 5.15% reached Thursday.

Let’s say Bernanke agrees that the April employment data shouldn’t dissuade the Fed from pausing after raising rates one more time, and that the central bank’s statement Wednesday nods to at least the possibility of going on hold (while still, most likely, talking tough on inflation). How would investors react?

An obvious risk in the stock market is that the news would be viewed as anticlimactic. Often, when events simply confirm what investors have assumed, those who bought on the rumor opt to sell on the actual news.

And plenty of people have considerable paper profit in stocks this year. The Dow is up 8% year to date. The Russell 2,000 small-stock index is up 16%. The average New York Stock Exchange issue is up 11%.

The gains are even bigger in many foreign markets.

But the prospect of an end to U.S. interest-rate hikes isn’t the only thing that has underpinned the market. The strength of the global economy and continued growth of corporate earnings also have kept people interested in equities.

In fact, without a solid economy and rising earnings, the appeal of stocks might have dimmed even if the Fed had already gone on hold. If you’re going to start worrying about a waning economy, let alone a recession, you probably would want to be very careful about increasing your stock bets.

Investors, for now, are back to believing in the Goldilocks economy: it won’t be too hot, or too cold, but just right. And that may turn out to be on the mark.

As Chan notes, however, it would be just like Wall Street, once the Fed paused, to suddenly begin wondering why they stopped. What do they know that we don’t?

As for bond investors, many of them last year had figured that as soon as the Fed stopped raising rates -- or even before that decision -- long-term interest rates would begin to decline.

But the bond market has become a much more nervous place this year. For one thing, the economy has refused to roll over, the April employment data notwithstanding.

“Aside from the hurricane-induced weakness at the end of 2005, the pessimists have been consistently wrong about the strength and resiliency of the U.S. economy,” says Michael Darda, chief economist at investment firm MKM Partners in Greenwich, Conn.

He thinks the pessimists remain misguided and the Fed will face pressure to continue raising its key rate, “ending the year closer to 6% than 5%.”

With the April wage inflation numbers and the continuing levitation of oil prices, bond investors have to wonder how much more inflation may be in the pipeline. Rising inflation, of course, is public enemy No. 1 as far as the bond market is concerned.

There’s another issue for bond investors: Is it worth accepting a 5.09% yield on a 10-year Treasury note if the Fed’s short-term rate goes to 5% and sits there? That isn’t much of a rate differential.

A little history might be instructive. Early in 1995, after doubling its key rate from 3% to 6% over the previous 12 months, the Fed stopped. Then it went into fine-tuning mode, trimming rates later in 1995, lifting them once in 1997, trimming again in 1998 and raising again in 1999.

All in all, the Fed’s rate stayed between 4.75% and 5.75% from mid-1995 to early 2000. The economy continued to grow briskly. The stock market boomed. And the 10-year Treasury note yield bounced between 5.5% and 7% for most of that period -- but was almost always well above the Fed’s rate at any given time.

Could the Fed be on the verge of another long period of holding short-term rates in a narrow range, as in the late 1990s? If the global economy stays on a decent growth track and inflation is muted, history could repeat.

In the near term, Bernanke sounds honest enough when he says the Fed, in deciding rates, will wait for “information relevant to the outlook” for the economy and inflation. What else can it do?

If it fears it’s gone too far and that the heretofore resilient economy is heading south, the Fed’s history suggests it won’t hesitate to cut rates again. That is, policymakers will cut if they aren’t also grappling with rising inflation.

Likewise, if economic growth stays strong and the inflation threat increases, odds are that 5% won’t be the final stop.

This shouldn’t be a great revelation to many investors, yet it might well become so -- if they thought strategizing was going to get simpler once the Fed paused.

Making the right decision is about to get tougher, not easier, for Fed policymakers. And probably for investors as well.

Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns, visit latimes .com/petruno.


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