Fed Stays Tight

The Fed kept rates tight at 5.25% despite the bond market demanding otherwise. I still side with many economists that believe they will continue to talk tough but cut rates in the first half of next year. This would allow the soft landing scenario and stronger growth in 2007 and 2008 and a prolonged expansion. We Shall see.......

Fed Keeps Focus on InflationEven as 'Growth Has Slowed'

Markets Discount ChanceOf Interest-Rate BoostsDespite Bank's Position

"WASHINGTON -- The Federal Reserve signaled that while the economy looks a bit weaker than a month ago, its forecast and concerns about inflation are unchanged, and thus interest rates are still more likely to rise than fall.

The Fed yesterday left its short-term interest rate at 5.25%, where it has stood since late June. In the statement accompanying its decisions, the Fed downgraded its assessment of the housing market and acknowledged "mixed" signals on growth. But its forecast of moderate growth is unchanged. Inflation remains its principal focus, and it still says its choice is whether to raise rates -- not to lower them.

Bond yields declined and stocks retraced most of their early losses as investors interpreted the statement as a concession by the Fed to markets' gloomier forecast of growth and more sanguine outlook on inflation. (See related article.) That, however, might turn out to be an overreaction. Fed Chairman Ben Bernanke has emphasized that rate actions depend on where the Fed thinks the economy and inflation will be in the future, not where they are today. And that hasn't changed.

The Fed said that "growth has slowed... partly reflecting a substantial cooling of the housing market." Its last statement, in October, didn't include the word "substantial." "Although recent indicators have been mixed, the economy seems likely to expand at a moderate pace on balance over coming quarters," it said. Inflation remains "elevated," and though expected to moderate, "inflation risks remain." Whether rates rise again will depend on new data, it said, in words identical to those used in October....

....The Fed and the markets have starkly different views of the path of interest rates, with the former maintaining a bias to raise them and the latter anticipating cuts of half to three-quarters of a percentage point in the coming year. Yesterday's statement did little to close the divide. Indeed, investors raised the probability of rate cuts a bit......

....Laurence Meyer, vice chairman of Macroeconomic Advisers, says the divide between the markets and the Fed is likely to be resolved one month at a time. If the data continue to support the Fed's stance, the Fed's language will remain the same, and markets will adjust their expectations as each Fed meeting approaches.

Richard DeKaser, chief economist at National City Corp. in Cleveland, predicted the Fed would stay on hold through all of next year. He attributed recent weakness in manufacturing to firms reacting to a buildup of inventories. Businesses are "not hunkering down and playing defense," he said, adding that his bank continues to see healthy loan demand from businesses.

But economists at UBS AG predicted rates will be cut a full percentage point next year as growth remains subpar, unemployment rises, and inflation edges down. Mr. Bernanke will be "somewhat more sensitive to growth versus inflation risks," they argued.

By Greg Ip - WSJ