Fed Watch: Headed for More of the Same

Here's Tim Duy with his latest Fed Watch:

I believe this is something of a dangerous time for a Fed watcher.  At the moment, the data and Fedspeak can be described as “monotonous” – it consistently points to higher rates, as dutifully reported by David Altig.  The danger here is twofold.  One is that the Fedwatcher gets complacent and fails to recognize shifts in sentiment at the Fed or in the economy.  Two, that in the need to feel like they are doing something new, he/she begins predicting the inevitable pause.  I have committed the first sin in the past, and came, in my opinion, close to committing the second in my last post. 

Little has come to my attention in the past couple of weeks to change my underlying outlook – the Fed will continue to raise rates until they see a clear shift in real activity. In this case, “clear” means “evident in the data,” not anecdotal evidence (I will comment on housing later in this piece). 

We are not seeing such clear data. The 3rd quarter GDP report was strong enough to keep the Fed on path, not withstanding the likely push and pull from revisions due to the September inventory and trade reports.  And while commentators such as Kash at Angry Bear have highlighted some weaknesses in the employment repots, the Fed will respond to the payroll weakness as hurricane distorted data, while the wage gains will be interpreted as signs of incipient inflation pressures. That is the interpretation that Fedspeak leads us to.

To be sure, inflation expectations appear to be dropping off. And some might see this as supporting a pause in rates. But the Fed is worried not so much about the rise in headline inflation (actual and expected), they are worried about pass through to core. As Mark Thoma reports, the pass through will only happen with a lag. Along these lines, note the story in Saturday’s WSJ reporting on growing signs of rising pricing power among firms.

I see that Fed St. Louis President William Poole declared that a hard landing, at least on the basis of internal imbalances, is highly unlikely.  Truly a dangerous statement. I vividly remember a Fed official (sorry, I don’t kiss and tell) assuring me in 2000 that “there is no way the US economy can have a hard landing.”  The basic idea was that the equity bubble was fundamentally confined to a small segment of the economy, and consequently the impact of its bursting would be confined as well. But whether or not you agree that the downturn was “hard” or “soft,” the Fed’s frantic rate cutting in 2001 suggests that they were caught off guard by the drop in activity. 

Incidentally, that little insight into policymaker psychology allowed me to call the Fed’s hardline approach through 2000 as I recognized the Fed was considerably less concerned than the bond market.  But I also became complacent, not to mention stubborn, and subsequently failed to look for the January 2001 intermeeting easing.

The lesson here is that the Fed can be heavily influence by prior beliefs; but also that those beliefs can change rapidly when the data hits some critical mass.

What prior beliefs might be at play? Indirectly, housing is a significant factor here.  I noticed some comments on William Polley’s site regarding our Econoblog discussion on the Wall Street Journal online. Some were surprised that we did not comment more on the housing “bubble.” Bill and I appear to share the same opinion on this:  The “bubble” itself is not driving policy. It is the incipient inflationary pressures that are the Fed’s concern, a position that stands in contrast to many commentators (thank you, David).

Greenspan & Co., however, recognize that tightening will likely work via a housing slowdown.  Does this mean a slowdown in housing will be enough to shift the Fed’s stance? Maybe – if the slowdown is sharp enough.  The anecdotal evidence so far, while interesting and though provoking, is too thin to hang policy on. Likewise with the data religiously monitored by Calculated Risk.  While these could be the precursors to a significant slowdown, I tend to believe that we will have to see an impact on consumers in the data for the Fed to be confident that overall activity is slowing to trend.  This is likely on the mind of Cleveland Fed President Susan Pianalto:

"As we start to see an increase in interest rates will that cause the consumer problems?" she asked rhetorically in response to a question. "I think it depends on whether that's gradual and how consumers adjust to that."

"In the past several years consumers ... have been very diligent in managing some of their debt in terms of refinancing to lower rates, but we'll have to ... keep our eye on this situation as the conditions change," Pianalto said.

My interpretation of Pianalto’s statement is that she expects consumer spending to weaken, but not rapidly or catastrophically.  Consequently the first signals of a slowdown will be events that match her expectations. If I am reading all this correctly, the Fed will not react until it sees significant stress on the consumer (assuming that is the correct channel of transmission) – again, in the data, not anecdotally. Note that such a point could still be months away:  A housing slowdown will need to become evident, then spread into consumption, and then show up in the data. 

Of course, consumption is just an example – an example that the Fed appears to be watching – of bearish signals. Another signal could be a swing in investment. Considering the conventional wisdom that recessions are investment driven events, I think that a slowdown in investment would be grounds to think about actual easing, whereas a consumer slowdown would be reason to pause. In any event, the hawkish rhetoric will ease only slowly, I suspect, until some critical mass of data is reached.

Overall, I come to the point where I find myself repeating the party line:  The Fed will continue to raise interest rates to keep inflation expectations in line. Monotonous. But while I repeat the line, I take care to watch the data (and rhetoric) to find that shift in policy sentiment. After all, as I noted last week, the tightening will have an impact at some point.

For public consumption, I offer this outlook for next year that I presented on October 18, prior to the latest GDP report (I underestimated Q3 growth).  You will notice that I play close to the razor edge of Okun’s law – I tend to be neither excessively optimistic nor pessimistic. I based my high estimate of aid relief for Katrina on news reports (numbers that ranged from $500 million to $2 billion per day). I am sympathetic to the prediction that housing market will curtail consumer spending next year. You may also notice that I expect the Fed to stop raising interest rate in early 2006, with the possibility of a cut at the end of next year.  I had March for the last rate hike in the back of mind when I wrote this.

Overall, I believe it is a reasonable baseline…but time and data will tell how much I adjust my outlook in the months ahead. I wrote this in September (the publishing department needs some lead time); currently, data suggests to me that the rate peak may be farther out than I anticipated. I am not wedded to this outlook; it simply represents the baseline in my mind.  Consistent with my anticipation of how the Fed will behave, I will adjust this forecast to any notable change in data or any perception of a change in the Fed’s outlook. Complacency is dangerous, and arrogance and stubbornness can lead you stick to a story long after its time has past.  Humbleness is a virtue in Fed watching – you are only as good as your last call.

[All Fed Watch posts.]

Comments

[anne]

My experience, direct and looking back, has been that long term interest rates tell most about what to expect from the Federal Reserve whether the Fed knows what to expect or not. This has been decidedly the case since 1994. Will this continue? So far bond buyers are expecting the Fed to continue along the same pace, and Ben Bernanke will likely wish to show toughness for a while.

[anne]

What is especially impressive to me is how well international economies as reflected in stock markets are weathering the increase in energy prices, the strong dollar, and lengthy Federal Reserve tightening sequence. Ah, and selected European social turmoil as well.

[calmo]

Excellent commentary [not just part of the Humble narrative, I swear] from Tim who does a masterful job of dodging those bullets of being called Monotonous or Dangerous.
Not like some.
Look how Poole fares:
"I see that Fed St. Louis President William Poole declared that a hard landing, at least on the basis of internal imbalances, is highly unlikely. Truly a dangerous statement."
A direct and well deserved hit in my book.
Ok, so Tim's audience is more particular ( like the AEI entertaining Chalabi last week) and the narrative more personal and sophisticated than the pronouncements from Poole that have an interest in not only forecasting but prescribing for the unwashed hoi polloi.
So easy for William to be dangerous with his flock and Tim to be dull, careful, and yes even monotonous with the nit-pickers.
Tim's narrative is flawed only at the end with this bit:
" Humbleness is a virtue in Fed watching – you are only as good as your last call."
He is as good (and mighty) as his narrative is in articulating that last move by the Fed --making the 'right' call is almost incidental to those of us with ears.

[Jill]

Why bother to just focus on their retoric or even the fact that they are raising interest rates. Just look at the ETF (XLF). Now why is that rising in the face of rising interest rates and tough talk from the Fed? Look at the FED'S H6 REPORT AND TELL ME WHAT YOU SEE. What a joke.

[anne]

http://flagship2.vanguard.com/VGApp/hnw/FundsVIPERByName

Sector Stock Indexes
12/31/04 - 11/11/05

Energy 31.4
Financials 5.3
Health Care 6.2
Info Tech 2.3
Materials -2.4
REITs 9.7
Telecoms 1.3
Utilities 11.2

[anne]

http://flagship2.vanguard.com/VGApp/hnw/FundsByName

Vanguard Fund Returns
12/31/04 to 11/11/05

S&P Index is 3.4
Large Cap Growth Index is 3.9
Large Cap Value Index is 5.0

Mid Cap Index is 9.7

Small Cap Index is 5.4
Small Cap Value Index is 5.0

Europe Index is 4.9
Pacific Index is 12.7

Energy is 34.5
Health Care is 11.8
Precious Metals 30.4
REIT Index is 9.6

High Yield Corporate Bond Fund is 1.1
Long Term Corporate Bond Fund is 2.3

[anne]

The financials index is up 5.3% for the year, and has slowly gained in recent weeks. The index has seemed well valued for some while, and while I never know why a market sector moves at a given time I am not surprised when a well valued sector begins to move. Possibly investors are convinced that the long term interest rates will not climb much more in this cycle. But, I sure liked financials for quite a while this year :)

[anne]

http://flagship2.vanguard.com/VGApp/hnw/FundsHoldings?FundId=0957&FundIntExt=INT

Notice the 10 largest financials make up 37% of the index, and valuations among these companies in particular were attractive several months ago for structual and macro-economic reasons. Investors should have noticed, especially so when financials internationally were decidedly strong in domestic currencies.