Secrets Of Success: Why the Fed is holding back this time

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The Independent Online

The Federal Reserve's decision to leave interest rates unchanged this week gave some momentary support to investors before the terror alert of Thursday raised a different level of uncertainty. The pause in the Fed's tightening regime raises the possibility that rate hikes may be at an end, despite the mounting and potentially alarming evidence of rising inflation in both the US and globally.

As always, the Federal Reserve faces a difficult balancing act between controlling inflation and sustaining economic growth, the two potentially conflicting objectives that its mandate requires it to pursue. It also has to operate within a set of broad political constraints that, by their nature, are never going to be explicit, but are real none the less.

With any luck, we will never see a return to the disastrous regime of Arthur Burns, chairman of the Fed during the Nixon administration, which signally failed to confront the inflationary threats that were to have such disastrous consequences in the mid-1970s.

Governments have learnt the hard way that central bank independence is a public good whose benefits far outweigh their opportunity cost, which is political control over short-term interest rate movements.

Whatever his other failings, Alan Greenspan was extremely successful during his 18-year term at sustaining the Fed's freedom of manoeuvre from visible political interference.

One of the challenges facing his successor, Ben Bernanke, is clearly how to ensure that the Fed's policy changes continue to be seen as the result of measured assessment of monetary and economic factors, and not political pressures.

At the same time, he has to earn the confidence of the financial markets, which (so it is always said) will dole out punishment in the form of rising bond yields if investors see signs that the Fed is losing its anti-inflationary credentials.

On that measure, the Fed is still well ahead of the curve, as its programme of rate increases have been mostly greeted by flat or falling bond yields and narrowing spreads since its programme of rate increases began in mid-2004, while the stock market has also been strong for most of that time.

In fact, judging by the recent behaviour of bond investors, who appear to me to have become remarkably complacent about the risk of a sustained rise in inflation, you could say that the so-called "vigilantes" of the bond market have gone on vacation and may no longer even be doing their job.

The current environment of high oil prices, rising inflation and (so far) continued economic growth is one that, in times gone by, would certainly have set alarm bells ringing far more loudly.

Of course, if the Federal Reserve was completely free to operate independently of the political process, we wouldn't have such a marked phenomenon as the presidential electoral cycle, which has been one of the most reliable guides to market trends over the past half-century.

"Looking back at history, when Great Britain was the dominant economic power of the world, this cycle would fluctuate anywhere between three and five years, averaging four," says Rashpal Sohan, a technical analyst at Rathbones Investment Management.

"More recently, however, the US has taken over this role and, because politicians cannot resist intervening with monetary and fiscal policy to help get re-elected, the cycle has phase-locked with the US presidential-election cycle, mandated at four years."

The chart, extracted from Rathbones research, summarises how well the market's highs and lows can be fitted to the four-year presidential cycle, with the lows in the cycle normally fitting the middle of each presidential term, and the market typically rising ahead of the election year itself.

It seems that it is easier to time the lows than it is to capture the highs, perhaps because rising markets have a habit of following their own distinctive behaviour when approaching a cyclical peak (also known as bull- market excess).

According to Rathbones' calculations, the typical bull market in the States runs for 36 months, and the typical bear market for 12 months. The figures for the UK market are similar.

If you believe that there is force in the presidential cycle (remember that all rules in markets are there to be broken in due course), where does that leave us in the summer of 2006?

We are in the middle of the presidential term, having experienced a bull market that exceeds the typical three-year average. It would be a surprise, in other words, if, following the market peak in the spring, this year was to break the mould and produce bull market-type returns.

At the same time, if you think that the presidential cycle has some influence - conscious or unconscious - over the actions of the Federal Reserve, you might argue that, if they are going to tighten further, they will be more inclined to do so this year than next year, which traditionally produces the best stock- market performance of the electoral cycle.

Much depends, of course, on how rapidly the US economy starts to slow in response to the succession of Fed rate increases.

The optimal outcome would be for growth to slow sufficiently to remove the inflationary pressures that are now clearly visible, which is the logical interpretation of the current shape of the yield curve.

But there are some much less reassuring outcomes, not least because inflation, once out of the trap, is notoriously hard to bring back under control.

Ben Bernanke and his Federal Reserve colleagues therefore have some tricky judgement calls to make if they are to avoid a painful rerun of past episodes. If there is one message that investors need to take on board, however, it is that the electoral cycle has far more explanatory power as a pointer to where markets might move next than conventional valuation measures offer.

That is why arguments that equities currently look relatively cheap on standard measures should be treated with caution at this point in the cycle.

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