What will the Fed do next?

In the early months of Federal Reserve Chairman Ben BernankeÆs tenure, the former economic adviser to President George W Bush is walking a tightrope as he wrestles with a pick-up in inflation driven by higher energy and commodity prices. Equity investors will be hoping he retains his balance at the levers of US monetary policy as too much tightening will slam the brakes on the economy, hurting equities, and too little will see inflation and long-term bond yields rise sharply. To be sure, US interest rates are always a focus for financial markets, but the uncertainty now about the course of Fed policy after years of a clear tightening bias makes policy settings of greater import to equity investors.

The most likely and by far the most desirable scenario for Wall Street investors is the central bank will soon end its two-year tightening cycle, having won a battle against inflation, and in so doing having promoted sustainable economic growth in the worldÆs largest economy. In the year ended March 30, US inflation-adjusted gross domestic product grew a relatively healthy 3.5%, and under the aforementioned circumstances, this type of activity could continue, with the dollar likely drifting lower rather than enduring a sharp sell-off. Whatever happens, we feel the dollar will be weighed by the oftdiscussed and long-running twin budget and current account deficits, and a likely narrowing of the interest rate advantage of US cash rates over equivalent rates in Europe and Japan. Still, if the currencyÆs decline is only gradual, this would cushion US equity markets by underpinning exporting companiesÆ earnings - their goods would become relatively cheaper in foreign markets than those of their competitors. This would allow US equity markets to outperform those in Europe and the Far East as they have done for the past six weeks, albeit during a period of stock price declines.

Since the US dollar embarked on its recent weakening leg from mid-April through the end of May, the Standard & Poor's 500 benchmark index fell less than the other two key markets. During the period, the S&P was down 2%, theDow Jones Stoxx 50 lost 5.4% and theNikkei 225 gave up almost 7%. And inearly June, Japanese stocks in particularsustained further heavy losses. Whilethis is hardly solace to someone heavilyexposed to US equities, we would arguethat if the Fed's target rate is no higherthan 5.5% by the end of the year,global equity markets could well stay intheir long-term uptrends helped byearnings growth, and the continuedstimulus to global economic activityfrom ongoing economic expansion inChina and India. But the problem forfinancial markets is that wishes don'talways come true and there are somemajor risks to this idyllic scenario forinvestors: the major problem isuncertainty. What will the Fed do next?Even it doesn't know the answer - andequity markets donÆt like this asillustrated by the recent losses in globalequities, particularly in emergingmarkets. Russian stocks, for example,were 20% off of their recent peak at theend of May, and the Brazilian boursehas been similarly affected.

Moreover, from an historicalperspective, financial crises, including precipitous declines in stocks, haveoften accompanied the appointment ofa new head of the Fed. Such volatility isjust one of the reasons we areexceedingly bullish on hedge funds thisyear, and expect they will be the best performingasset class in 2006,although this is a discussion for anotherday. BernankeÆs predecessor, therevered Alan Greenspan who headedthe Fed for more than 18 years, dealtsuccessfully with the 1987 stock marketcrash just two months into his tenure.Before him, Paul Volcker in 1979 wasconfronted with the oil price shock,which required his Fed to almostdouble its target rate to 20% by early1980 to curb inflation.

Bernanke will be hoping neither oftheir experiences is repeated during thefirst year of his watch. But recent economic data show theinflation dragon is yet to be slain. This headline reading for inflation hasbeen picking up since October, whileôcoreö inflation, which strips out theprices of volatile items such as freshfruit, petrol prices, and mortgage costs, has been in a clearupward trend since early 2004. What is of equal concern isa recent jump in producer prices. In April the PPI rose0.9%, its biggest jump in seven months

The Fed canÆt ignore these inflation pressures as to do sowould send US Treasury yields higher to the detriment ofthe housing market, which is threatening to weaken. TheFedÆs Lacker, who is a voting member of the FOMC, saidfaster US inflation reduces the chances the Fed will pause.

What is clear about the outlook for the US economy isthe dollar will weaken. A rate hike ôpauseö brings inflationinto focus and possibly lower ôrealö interest rates, whichwould hurt the currency, while further rate increases couldslow economic activity with a similar result.To adapt a phrase from Shakespeare, to hike or not tohike, that is the question, and while we remain optimisticabout US equities and the FedÆs ability to fight inflation, thetightrope analogy for policymakers appropriately describestheir job in 2006.

The above article is an updated version of an article published in the Summer issue of Asian Private Capital, a supplement to FinanceAsia magazine.