(James Saft is a Reuters columnist. The opinions expressed are
By James Saft
July 30 The Federal Reserve carried on its merry
tapering on Wednesday, and though the accompanying statement was
probably rightly viewed as dovish it signals a potential sting
down the road.
For now, Fed policy looks set to continue to support risk
assets, with a less certain and probably less strong impact on
As expected, the Fed cut bond buying by $10 billion per
month, remaining on course to end the program in October.
The real news, which drove a rally in both stocks and
government bonds, was in the statement, which expressed
continued dissatisfaction with labor conditions but also a newly
relaxed posture about the threat of deflation.
Given the laser focus of Yellen and her core of supporters
on underemployment and stagnant wages, that dovish read is
probably about right. Longer term, the shift on inflation might
prove to be more significant.
So what did the Fed say that was new? Old language about
"elevated unemployment" was dropped in favor of a new key
phrase: "There remains significant underutilization of labor
That's neutral to dovish because consensus has for several
months been that the Fed views improvement in the unemployment
rate as a falsely flattering signal about the state of the labor
market. The beauty of "significant underutilization", at least
from an equity bull's point of view, is that it has no hard and
fast numbers attached to it.
That gives the Fed license to read a broad mix of labor
market data, and probably the ones to watch are wages, part-time
employment and participation. Not till we see some decent
recovery in a broad mix of labor data are we going to need to
ratchet forward expectations for when the Fed actually hikes
Given that wages haven't just been stagnant for quarters, or
even years but by some measures decades, you can see why this
stance gives investors hope that the good times for risk assets
Now for the potential sting in the tail.
The Fed is less afraid of deflation, if not yet expressing
concern about inflation.
"The likelihood of inflation running persistently below 2
percent has diminished somewhat," according to the statement, a
view in line with recent upticks in some prices.
"The bottom line is that the Fed are giving strong
indications for the first time that they are moving towards
hitting both targets," Steven Englander, foreign exchange
strategist at Citigroup, said in a note to clients.
"This does not mean that policy has to become hawkish
overnight, but the motivation for keeping real and nominal
interest rates at such extraordinarily low levels has eroded and
that is what is new in the statement."
GROWING GAP BETWEEN MAIN STREET AND DOW JONES
Combine that with the new information from today's
second-quarter GDP report about one key measure of inflation
actually running ahead of the Fed's 2 percent target and we
might have a slight problem. That doesn't mean we'll get a Fed
trying to play catch-up to inflation, in fact it seems unlikely,
but we are closer on at least one measure to territory in which
hawkish arguments resonate.
One area unlikely to upset expectations for when a rate hike
comes is today's GDP data, which showed a 4 percent growth rate
in the second quarter and a revised and improved 2.1 percent
fall in the first quarter.
The headline figures were healthy but much of the recovery
was a build in inventory. Inventory stocking accounted for 1.66
of the four percentage points of growth, but for that to be
truly meaningful those inventories will need to be bought.
And while there was a nice bump in business investment, a
goodly portion of the auto sales that goosed growth were likely
subprime-loan-enabled car purchases, a source which won't fill
policy makers with confidence.
Bottom line, the GDP numbers showed an economy continuing to
slouch along rather than one accelerating towards wage growth.
My guess is that the Fed probably wishes that financial
markets would react differently to what it is saying. It would
be far more convenient, for them, if interest rates backed up
quite a bit in coming months, setting the stage for a rate hike
in 2015 without any kind of market whiplash.
That isn't happening, and for now the Fed, particularly
Yellen, seems more interested in buttressing employment. So far
the policies that that justifies seem to have a bigger impact on
asset values than on jobs and wages.
Look for the divergence between Main Street and the Dow
Jones to continue to widen.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at email@example.com and find more columns at blogs.reuters.com/james-saft)
(Editing by James Dalgleish)