Fed Watch: Another Meeting, Another 25 Basis Points

Tim Duy has a Fed Watch in anticipation of Tuesday's FOMC meeting:

The above title makes the Fed sound just a little too predictable. But the hawkish rhetoric from Fed officials has been quite clear, and last week’s data adds to the case for additional tightening at what we have come to know as the measured pace. Today we will see it again with, I suspect, little change in the accompanying statement.

Taken at face value, the GDP report confirms, once again, the resilience of the US economy. Final sales to domestic purchases clocked a 4.2% gain, virtually identical to the Q2 figure. Consumers prove, once again, they are down but not out. Investment spending looked a bit anemic, but this was foreshadowed in the most recent Fed minutes, as well as a lackluster September durable goods report. And while PCE inflation accelerated, core-PCE again decelerated, falling to a 1.3% rate. All in all, simply not much to worry about in this report see David Altig for a complete rundown on GDP blogging.

Still, if one were inclined to go looking for red flags in the report, where would they turn? The consumer certainly ended the quarter on a weak note, with real spending down a second consecutive month. The strong quarterly showing by consumers was driven by the July surge in durable goods spending, which in turn was driven by auto incentives. Any potential gain in September was lost to higher energy costs from Katrina and Rita. Consumers made it through the third quarter, but came out more bruised than the headline figure suggests.

But a strangled consumer is not a surprise for the Fed; the consumer confidence figures have been telling that story for two months now. Moreover, the Fed recognizes that some demand needed to be destroyed in response to the energy shock. The alternative would be a greater chance that energy inflation would spread into the core. And Fedspeak leaves no doubt on where policymakers stand on that issue. Also note solid growth – 0.5% ‑ in nominal income, after adjustment for Hurricanes Katrina and Rita. The means to spend was in their pockets, it was simply sucked away by higher energy costs. Indeed, with gasoline prices coming down, the consumer may be in better shape than expected despite higher heating costs this winter.

So, overall, incoming data suggests the economy remains on cruise control despite the series of speed bumps the Fed keeps laying down. Does this mean the Fed just keeps laying down more bumps? For the rest of this year, the answer appears to be yes. I think the Fed is comfortable chasing the 10 year bond. Indeed, the bond market has recently cleared the way for additional hikes, with the 10 year yield rising above 4.5%. Moreover, the minutes of the last meeting report that:

Even after today's action, the federal funds rate would likely be below the level that would be necessary to contain inflationary pressures, and further rate increases probably would be required.

Rate “increases,” plural, being the important point, and I see little reason to expect that the FOMC’s judgment has changed on that point. Beyond December, things get a bit fuzzier, in my opinion. Perhaps I am feeling the same unease reported by David Altig last week, as traders were paring bets of a January rate hike. But despite an economy that has remained resilient to what by tomorrow will be 300bp in rate hike, I would hate to forget one of the tried and true mantras of Wall Street:

Don’t fight the Fed.

Eventually, rate hikes will start to dampen real activity. The Fed, of course, is aware of this. Again, from the last minutes:

However, some sentiment was expressed to consider changes to forward-looking aspects of the statement at upcoming meetings, in part because of the considerable reduction in monetary policy accommodation that had already been accomplished.

While policymakers might see the need for additional rate hikes, they realize a lot is also in the pipeline as well. With a considerable amount of accommodation removed, the Fed, I suspect, will soon start paying more attention to data that comes in on the weak side.

So what will the Fed be looking for in that respect? The Fed will be watching for additional evidence of a slowing housing market. Again, the point is not housing itself, but the expected negative impact of a housing slowdown on consumer spending. I doubt the early data and anecdotal evidence is enough to convince them that the housing ATM is closed, but if the housing bears are correct, we could see evidence in that direction pile up over the next couple of months.

Another red flag for the Fed would be sputtering investment spending. Greenspan’s speeches and the minutes suggest that policymakers expected investment spending to hold strong, and they were a little disappointed by what they were seeing at the last meeting:

Meeting participants noted that, even prior to the hurricane, business fixed investment had been somewhat weaker than expected. The softness was somewhat puzzling, as sales were growing, business balance sheets appeared quite strong in the aggregate, profitability was high, and financing was readily available and relatively inexpensive for most firms. Although the apparent sluggishness could reflect only short-term fluctuations in volatile data series, some evidence suggested that it may also have stemmed from concern among business executives about the effects of high energy prices.

Fed Atlanta President Jack Guynn reiterated this unease about the course of investment spending in his Oct. 20 speech.

Another question is if the Fed will deliberately invert the yield curve. To date, policymakers haven’t expressed much concern about the yield curve. But I suspect some posturing was involved here – you can’t maintain expectations for further rate hikes while at the same time fretting over a recession indicator. I doubt that Greenspan & Co. – or a future Bernanke & Co. – will push the fed funds rate above the 10 year rate. If the curve inverts, I believe it will be the result of the long end slipping. Right now, the Fed would be willing to go to 4.25%, maybe even 4.5%, essentially cutting the gap to zero. But if the long rate overshot in a post-Bernanke announcement frenzy and is due for a pullback……?

Also, with rates back into the “4’s,” the Fed is eventually going to focus on actual inflation data. And so far inflation appears contained to headline numbers, with what looks like a solid deceleration of core inflation in place, at least in the GDP report. To be sure, the recent energy price spikes haven’t had time to work their way through the system, but neither have recent and expected rate hikes. Moreover, it is difficult to imagine that inflationary expectations become entrenched without wage inflation to back them up. And last week’s Employment Cost Index report sure does not point to runaway wage inflation, with a paltry 2.3% wage gain compared to last year. In fact, I can’t remember a period of ongoing monetary tightening in such a weak wage environment.

Still, the inflation story was – and will remain for the rest of this year – useful justification for normalizing the fed funds rate, and I continue to expect additional rate hikes. But as rates head into the midpoint of San Francisco Fed President Janet Yellen’s 3.5-5.5% neutral range, the bar for additional hikes will likely rise.

Of course, none of these bearish things might happen and the Fed could happily keep raising rates well into next year, chasing strong growth, higher inflation and a falling 10 year bond. They are just the things I would be watching out for at this point.

[All Fed Watch posts.]

Update: David Altig has the probabilities for increases in the federal funds rate through January.

Update: Andrew Balls of the Financial Times has thoughts on the measured pace language:

Fed expected to raise interest rate to 4%, by Andrew Balls, Financial Times (non-sub.): The Federal Reserve is expected to raise interest rates on Tuesday and signal further increases... While there has been no indication that the Federal Open Market Committee will change its judgment that monetary policy remains “accommodative” and that it will continue to raise rates at a “measured” pace, there is a widespread feeling that part of the statement will need to change soon. ... One concern is that the federal funds rate is no longer obviously well below the so-called “neutral” level, at which monetary policy neither restricts nor stimulates activity. But there does not yet appear to be a consensus on what should happen next, and the current language in the Fed's statement is seen as acceptable for now, with the FOMC likely to raise rates again in December...

Comments

[anne]

"Don't fight the Fed" is precisely what Wall Street appears intent on this year. Look to the sectors that are carrying the market :) Whether the market is more or less robust is not the point this year, rather sector sector sector. Much like 1994 or even 2000. Remember 2000 began the bear market. The Fed finished a tightening sequence that had been stopped for a while by the new century worry. The sequence finished in May with a 50 basis point move; a foolish move but expected. The bear market however was marked with a 60%, yes 60% gain, in large company drug stocks. Sector sector sector. Don't fight the Fed. I never would :)

[anne]

"In fact, I can’t remember a period of ongoing monetary tightening in such a weak wage environment."

Yeah, yeah. That's what bothering.

[James Hamilton]

As always, a very nice analysis from Tim.

[calmo]

Housing price trends have got to come down to official inflationary values it seems to me.
Maybe even that is not enough as those 2brm starter houses in San Diego represent capital gains of several hundred thousand --a tidy little bank account all on it's own even if prices plateau, no? Even if the prime rate presses on to 5%, what effect does that have on the homeowners who have this alternate source of money they can draw on? [Do house values have to retreat in order for these inflation fighter rates to work?]
I fail to see the tightening on the homeowner, especially as long as the house appreciates faster than the mortgage rates. Isn't the UK housing market a case study on the capacity of the appreciated house to tide the consumer over even during a period when housing prices have remained constant?

[anne]

The housing market in America is actually many local housing markets, markets that move in different ways at various times. A robust market in Omaha has little to do with a robust market in Mobile. Markets along the coasts, urban markets, might seem to have common characteristics, and to move together, but I am not sure this is really so as I look back.

What I have done is look to the commercial real estate market in the form of real estate investment trusts over the last 30 years, to gain a reflected sense of the housing market as a whole. Possibly a poor reflection, but I follow the REIT index nonetheless. The REIT index these 30 years has paced not inflation, but the stock market. The index has been robust through the period, with remarkably little volatility, however REIT valuations are startlingly high at present. What the heck does this mean?