The Hindu Business Line : Fed pause will not deter yield curve steepening

Another Fed meeting, another rate rise of 25 bps, taking Fed funds to 5 per cent. It was the 16th consecutive upward move, which started in June 2004.

When will it end? The short answer seems to be that the Federal Open Market Committee (FOMC), which sets US interest rates, itself is in doubt.

For, consider the wording of the ubiquitous post-meeting statement, which describes economic growth as quite strong `but likely to moderate to a more sustainable pace'. This would suggest the Fed thinks there is no need for further rate hikes. Lest markets jump to this conclusion, it cautions that `some policy firming may yet be needed'. This is again qualified with the remark that `the extent and timing of ... firming will depend on the economic outlook'.

So are all bets off as far as a Fed pause is concerned?

Delving into the minutiae of the statement does give the impression that at least a temporary halt is more likely than a continuation of the rate increases. Whether it will be now or later is the issue.

The FOMC believes the American economy is likely to slow in the near future, given the toll tha high energy prices extract from businesses and consumers. Another red flag is housing, which is seeing falling demand and softer prices. This means the diminishing wealth effect from soaring property will negatively impact consumer spending.

Of course, even if the FOMC, to a man, wants to call finis to higher rates, it cannot do so forthrightly, because a central bank's credibility depends on its inflation-fighting credentials. And no one knows this better than Mr Ben Bernanke, the new Fed chairman. The first thing he has to do is to convince markets that he is no slouch when it comes to inflation fighting.

For die-hard monetarists (Mr Bernanke does not belong to this camp), inflation is always lurking around the corner, even in the worst of times.

Meanwhile, the conundrum of falling bond yields amidst rising Fed rates has been resolved with the yield curve assuming its normal upward-sloping posture. The period of inversion is over and sanity is back in the bond market.

Where are we headed? The coming weeks are likely to see yields fight a battle between weaker growth and a falling dollar. The latter is negative for bonds.

With energy and commodity prices still on a high, there is little room for bond yields to fall much, even if the Fed pauses. In a crunch, e.g., a market crash because of foreigners selling US assets, the Fed will follow the time-honoured custom of cutting rates. But this time bonds may not respond that positively. This means a significant steepening of the yield curve is in store.

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