Disconnect Between the Fed and the Markets

The markets expect the Fed to cut interest rates over the next year. The Fed doesn't. Greg Ip reports:

Fed Is Hampered By Past in Effort To Sound Warning - WSJ.com: Federal Reserve officials -- unlike bond investors -- think the economy is a lot sounder today than at the end of 2000 and in early 2001, when the Fed abruptly reversed course and began a string of interest-rate cuts. Yet Fed Chairman Ben Bernanke's effort to convey the message that today's conditions are different is hampered by the Fed's lack of candor back in 2000.

Fed officials, who have universally voiced concerns about inflation, are expected to keep short-term interest rates steady at 5.25% at their policy meeting next Tuesday. But bond markets have priced in a small chance of a rate cut next week and three one-quarter percentage-point cuts over the next 12 months.

Markets anticipate those cuts in part because they see parallels to 2000. A technology-stock and investment bust began to unfold in the summer of that year, yet in November the Fed still said its principal concern was inflation, not economic growth. Seven weeks later, with stock prices tumbling and businesses canceling investment plans, the Fed made the first of 13 interest-rate cuts.

Like stock prices then, housing prices today are turning down after a long run-up. But there is little sign the decline has spilled over into the rest of the economy. Stock prices are up, not down. Officials acknowledge recent data have been weak, especially for manufacturing and commercial construction, and they are expected to closely scrutinize the November jobs report, to be released Friday.

The weak data, however, haven't been corroborated by anecdotal evidence from the Fed's extensive business contacts. The Fed's recent "beige book" roundup of regional business conditions found "moderate growth" and "tight" labor markets.

Fed officials thus appear content with a forecast of moderate growth over the next few quarters, then a rebound in mid-2007. "I don't think that the data we have seen are out of line" with that forecast, Federal Reserve Bank of Chicago President Michael Moskow said Monday on CNBC.com.

The Fed has viewed the housing pullback as the principal threat to growth. The slump prompted Fed Vice Chairman Donald Kohn to say two months ago that the risks to growth were "skewed a bit to the downside."

Since then, as the decline in housing sales has moderated and shown little sign of damping consumer spending, officials' concerns have eased. Last week Mr. Bernanke indicated he saw the risks to growth as balanced.

In late 2000, the Fed's business contacts were getting worried, and the stock market was crumpling as profit warnings proliferated. "Everything was pointing up and, all of a sudden, everything started pointing down," recalls Edward Gramlich, a Fed governor at the time. Today, "the key thing is whether the weakness in housing -- and now autos -- feeds over into consumption at large, and as I understand it, it really hasn't"...