Federal Reserve: Moving closer to neutral

After the release of the minutes from the November Federal Reserve monetary meeting, the market is beginning to realize the end of the rate hikes in the U.S. could come as early as the first quarter. The minutes revealed some members cautioned against “going too far with the tightening process” and discussed the need to change their outlook on interest rates “before long.”

The minutes from the December meeting also included a shift in tone that suggested the Fed may be ready for a change. In the statement, they replaced the phrase “accommodation can be removed at a pace that is likely to be measured” with “some further measured policy firming is likely to be needed.” This was taken as a sign the Fed believes interest rates are now out of the accommodative range and any further increases would move them above the neutral range. However, to get an idea of what the Fed will do next, all the market has to do is look at the UK. After cutting interest rates in 2001 and again a few times in early 2003, the BOE began to raise rates in November 2003. They increased rates aggressively until summer 2004, at which time they kept rates unchanged until August 2005, when they cut rates for the first time.

Today the U.S. is where the UK was in the summer of 2004. Having already delivered 350 bp of tightening, the Fed is ready to mimic the BOE’s move and leave rates unchanged for a few months. Given the dollar’s rally last year was driven primarily by the Fed’s aggressive rate hikes, the end of their rate campaign could mean an end to the dollar’s rally. We are already seeing evidence of this as the dollar begins to weaken in early 2006. Should the speculation of a move to neutral become an announced reality, the floodgates could open, letting out any remaining hopefuls who may have been clinging to the hope of 5.00-percent rates. Therefore, the market is simply sitting back and waiting for the Fed to announce they are done, at which time bears may come out of their caves and aggressively claw the dollar.