(James Saft is a Reuters columnist. The opinions expressed are his own)
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 Main Street.
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 resources."
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 rates.
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 can continue.
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)