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Monday, September 05, 2005

Fed Watch: Too Contrarian on Monetary Policy?

Tim Duy gets back from vacation at the beach, shakes the sand out of his ears, clears his head, and gives us this:

As the horrific devastation (to people and property) from Katrina deepened, it became apparent that I took a remarkably contrarian position (thank you David) in my last post.  Luckily, I don’t work for the Bush Administration, so I can admit to errors.  Of course, I was not alone in my contrarianism. Regarding the minutes, former Fed Governor Lyle Gramley was quoted in Bloomberg the day after the hurricane saying:

''This points pretty firmly to continued increases at every meeting this year,'' reaching 4.25 percent by year-end, said former Fed governor Lyle Gramley, now a senior economic adviser at Stanford Washington Research Group in Washington.

So perhaps we are both entirely clueless. Our club would be a bit bigger if we include Philly Fed President James Santomero (channeled by Mark Thoma), who said that the national impact of Katrina would likely be limited. Similar views are also held by CEA Chief Ben Bernanke (see here and here) whose view is that “...reconstruction will add jobs and growth to the economy.”

Add, even given the bond market’s decisive turn, some analysts still expect the Fed to stick with the current plan and continue raising rates.  From The Wall Street Journal:

The payroll details show decent gains in most services, though retail (+12K) was soft. Construction was up a hefty 25,000, while manufacturing was down 14,000. Overall, report shows the pre-Katrina labor market continuing to tighten, which is why the Fed will keep raising rates. Next month, payrolls will plunge; our guess is -500,000. -- Ian Shepherdson, High Frequency Economics

In contrast to these views, conventional wisdom now has it that Katrina represents a massive negative shock that could plunge the economy into recession. Consequently, markets are quickly pricing out additional Fed rate hikes, and the 10 year Treasury rate has slid down to around 4%.  The collective wisdom of the markets has spoken.  Still, some Fed watchers expect a continuation in rate hikes, others see a pause in September, and then a resumption later in the year, and others think the Fed is done, period.  Given the bond market’s reaction, why would anyone still believe the Fed will continue to tighten?

Part of the answer, I believe, is a hesitation among many Fed watchers, myself included, to shift positions without complementary Fedspeak.  Note that we have little information on Fed thought at the moment.  Outside of the Santomero comments, and a few thoughts on inflation from Fed staffers, there has been essentially no Fedspeak. All we have to work with is where the Fed left off before Katrina.  Greg Ip of the WSJ sums this position up with:

Fed officials have set a relatively high bar to pausing. Although short-term interest rates are higher, overall financial conditions are still stimulating growth, particularly because of a decline in long-term rates set in the bond market and a weaker U.S. dollar. Were the Fed to pause and later determine it was unneeded, it might find that it has added to the housing market's froth and to inflation pressures.

Another part of the answer regards uncertainty surrounding the nature and impact of the economic shock delivered by Katrina.  What is the hit to demand from the cessation of business activity along the Gulf coast?  How many billions of dollars will be spent on reconstruction?  Are rising gas prices a supply or demand side event, strictly speaking?  Etc, etc.

Regarding the demand side of the equation, I tend to see the negative impact as relatively short lived (and don’t forget that automatic stabilizers will come into play), while the stimulative impact of reconstruction to be substantial and long lived.  To get an idea of the numbers, note that FEMA is currently spending $500 million dollars a day; this spending annualizes up to a rate of $182 billion dollars a year. Congress’ authorization of $10.5 billion dollars will only last 3 weeks and is clearly only a drop in the bucket that is to come. 

Katrina exposed vividly and graphically the sharp class divisions within the United States.  Politically, I don’t see how the Administration can let that wound fester for long, especially as refugees migrate to Congressional districts across the country. (I don’t see how from a humanitarian or moral perspective as well; I am just am not convinced the Administration cares.  Indeed, the Senate leadership apparently is more worried about tax cuts for the wealthy than anything else). Money – big money – will be coming from Washington.  And we know that big money for one state never comes without big money for others.  I am betting on substantially higher deficits ahead.

On the supply side on the equation, I agree with Caroline Baum. Before Katrina, demand was the driving force behind higher energy prices.  Hence I never expected higher oil costs to be recessionary. Katrina, in my view (and likely the Fed’s as well), represents a significant supply side hit.  And the restrictions on productive capacity extend beyond just energy.  From the New York Times (thank you anne):

...But with gasoline and diesel prices being sharply affected by the loss of refining capacity caused by the storm, shifting to other ports will create costly logistical complications that will probably be passed to consumers in the form of higher prices, shipping firms said.David Feider, a spokesman for Cargill, said it was "not feasible" to divert grain shipments to trucks or trains because of the high cost and the loading infrastructure required. Imports are not faring any better. Shippers were scrambling to arrange alternative ports for incoming shipments of oil, chemicals and steel additives. Millions of pounds of coffee remained in storage in New Orleans. "Everything is at a standstill right now," Mr. Feider said…

The upshot is a blow to the economy’s ability to produce goods and services, as noted by Caroline Baum, who muses:

If productive capacity and, hence, the economy's potential growth rate, have just been reduced, why stimulate demand for the limited supply?

To be sure, a supply side shock can cause a recession, with its toll on output and employment.  But supply shocks cause inflation as well, and that is what I argue will be a problem for the Fed.  Does the Fed really want to accommodate a supply side price increase?  From The Wall Street Journal editorial page:

Which brings us to Katrina's impact and the Federal Reserve. The airwaves yesterday were full of suggestions -- pleas, really -- that Katrina's damage should cause the Fed to stop its slow and steady path of monetary tightening. Philadelphia Fed President Anthony Santomero even encouraged this wishful thinking by hinting to CNBC that this wasn't out of the question.

Now, one of the Fed's duties is to provide financial liquidity in a crisis. But while Katrina is a human calamity with economic consequences, it is not so far a financial crisis. Oil prices have spiked above $70 a barrel in anticipation of reduced supplies. But the Fed policy would only cause prices to rise further if it printed more money that would end up chasing scarcer supplies. This is precisely the trap the Fed fell into in the 1970s, easing money to help the economy offset rising oil prices, only to cause oil prices to spike again. The cycle kept repeating itself and the result was stagflation.

Chairman Alan Greenspan's Fed has already contributed to higher oil and commodity prices by keeping monetary policy too loose for too long in 2003 and 2004. This is beginning to show itself in rising consumer prices this year and is likely to continue to do so in the coming months. The last thing the Fed should do now is give the world's investors the idea that it can be bumped from its anti-inflation resolve by an act of nature, even one as destructive as Katrina.

Unlike September 2001, the economy has considerable underlying strength. Katrina will no doubt reduce its growth in the third quarter but that might also lead to a rebound in the fourth. Any sign that the Fed has gone soft today will only mean that interest rates will have to go that much higher in 2006 to head off any inflationary expectations.

Can we attempt to continue to allow Americans to consume the same amount of goods and services as they did prior to Katrina, while at the same time caring for refugees and rebuilding New Orleans, without generating inflationary pressures?  Possibly – as long as we can rely on the rest of the world to continue to provide us the additional goods.  Enter tankers of gasoline on their way from Europe.  The trade deficit will continue to swell, and existing imbalances will only be exacerbated.  This will work as long as foreign investors are willing to hold dollar denominated assets and not demand goods and services…this certainly could be the Fed’s plan, but I would think an increasingly risky one.

But when all is said and done, the financial markets, however, have rejected an ultra-hawkish view and have instead embraced the position that the Fed will pause in their campaign, perhaps as early as the next meeting.  To be sure, a break to assess the situation doesn’t appear to be that much of a concession – they can always come back to the table later this year, although they will have to manage expectations accordingly.  And after all, the Greenspan Fed has never met a crisis that can’t be cured with a quick rate cut. 

But I can’t shake the feeling that the Fed will be thinking that if we are about to slide into another recession, stagflation will be the name of the game.  And they won’t want to risk ratcheting up inflationary expectations if such an outcome is on the way.  While I would agree that the probability of a policy shift has risen, before I change my call for more rate hikes, I really want to hear the Fed tell me I’m wrong.  And this week Chicago Fed President Moskow and San Francisco Fed President Yellen will have that opportunity.  We will all be listening closely.

    Posted by on Monday, September 5, 2005 at 05:22 PM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (2)  Comments (3)

          

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    Listed below are links to weblogs that reference Fed Watch: Too Contrarian on Monetary Policy?:

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