Investors have not quite known what to make of the Federal Reserve’s latest decision. Equities rose on the news, only to fall subsequently; the dollar fell, only to rise. Treasury bond yields moved modestly higher.

The markets got the pause in rates they had been expecting but not the “closure” beloved of psychological dramas. As the Fed made clear, if the data deteriorate, further rate rises could occur.

Since it is well known that economic data are erratic (in the jargon, they contain a lot of noise), and are subject to widespread revisions, that creates uncertainty. And that undermines investor sentiment and leads to volatile markets.

But what else was the Fed to do? Had it been more decisive, it would have been damned either way. A rate rise would have been dubbed as overkill in the light of the slowdown in second quarter growth in gross domestic product and the signs of weakness in the housing market. A definitive rate pause might have smacked of complacency in the wake of the recent core inflation numbers.

A Reuters survey of primary bond dealers showed how the outlook is still finely balanced; 13 believe the peak in rates has been reached, while 10 think further increases may occur. But only four expect a move at the next meeting.

In essence, the Fed has had to make a gamble – that the lagged impact of its 17 previous rate rises will subdue the inflationary pressures still in the system. If this gamble fails, then the US central bank’s credibility will be damaged at an early point in chairman Ben Bernanke’s tenure.

However, the recent decline in Treasury bond yields suggests the markets are not too concerned about inflationary pressures. Breakeven inflation forecasts, as reflected in the Fed’s favoured five year/five year forward rate, have gone from 2.5 per cent to 2.66 per cent.

But Tim Bond, head of global asset allocation at Barclays Capital, thinks the bond market has mistaken the redistribution of consumer spending towards energy as the sign of a more general slowdown. The real GDP numbers have slowed (but may be revised upwards for the second quarter); nominal GDP is still racing ahead. The Fed may have more work to do.

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