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August 21, 2000

Federal Reserve Isn't Taking Center Stage in the Market
By Terzah Ewing, The Wall Street Journal

Fed Must Tighten to Ward Off Inflation ... Weiss comments

NEW YORK - It may be as unwise to write off the Fed as to fight the Fed. But that's what a lot of investors are doing right now.

Talk to most Wall Street traders and analysts these days and you'll find few worried about the Federal Reserve policy meeting Tuesday. They think the Fed won't raise interest rates this time because there are enough signs that the much-sought economic soft landing is happening.

The growing optimism about the Fed has made for a relatively strong August so far for stocks; the Standard & Poor's 500 index is up 4.2% so far this month, leaving it up 1.5% for the year.

Give credit for this to perceptions of the Fed's easier stance. Steve Shobin, chief technical analyst at Lehman Brothers, said the broadening advance comes from "confidence in the bond market, confidence in a more accommodating Fed posture, and the fact that people are "looking askance at high" price/earnings ratios.

The Fed began raising rates in June 1999 in an effort to slow the economy and keep inflation at bay. Since then, it has increased rates six times. Often, the increases sparked brief market rallies as investors figured the worst of the rate increases were over, only to be reversed as that proved wrong. Still, despite those stumbles, higher interest rates haven't produced the "hard landing" of a recession, and other than the hyperactive Nasdaq composite, none of the major indexes slipped into bear-market territory (generally defined as down 20% or more from their high). Indeed, after declining 9.16 points to 11046.48 Friday, the industrial average stands just 5.8% below its high. The S&P; 500 is a mere 2.3% off its high.

This recent optimism could still come to naught. Though most indicators show little sign of inflation, the picture isn't unambiguous. Bridgewater Associates in Westport, Conn., point out that several key statistics, including manufacturing output and housing starts, have recently ticked up again. And they noted that even though the July consumer-price index report was shrugged off by the market, the barometer is still edging up.

That, says Bob Prince, director of research and trading at Bridgewater, implies that the slowdown that investors are celebrating "was a temporary blip" and inflation remains an immediate threat. If that proves true, and rate increases again enter the picture, bonds would likely suffer, Mr. Prince says. "It cuts both ways for the stock market: Strength in the economy would be good for the stock market until it became clear that the Fed was going to tighten aggressively again."

So while the Fed isn't likely to raise rates any more for the time being, it also isn't about to start lowering them, which is what stocks really need in order to rally strongly again.

There are other reasons to be wary this week. There's the tendency of investors to "buy on the rumor, sell on the news." Stocks have tended to rise before Fed meetings because investors are anticipating the outcome but then fall afterwards as those investors take profits.

There's also the chance that even if Fed policy makers left rates alone, they may reveal a "bias" to lift rates later because of the continued risk of inflation.

There is clear evidence that inflation remains a threat. As this article points out, the July consumer price index indicated a definite increase in prices, even though the market chose to ignore it. Plus, higher oil prices will become an even bigger issue as people stock up on heating oil for the coming winter.

The Federal Reserve cannot sit idly by while inflation creeps into the economy. If they do not raise rates at their meeting tomorrow, look for some stern language about inflation in the ensuing press release (normally out about 2:15 pm). Then, expect a rate hike at its next meeting in October - perhaps even sooner.

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