Fed Watch: Read His Lips

Tim Duy with a Fed Watch:

Read His Lips, by Tim Duy: Bernanke & Co. want to pause. They want to pause badly. We were supposed to have figured it out when the minutes of the last FOMC meeting were released, and when the point about an imminent pause was reiterated by San Francisco Fed President Janet Yellen. Financial market participants, however, seemed unwilling to fully accept that a pause would soon come – at least that is the story told by the rebound in expectations for a June rate hike reported by David Altig. So Bernanke came to the table yet again to make clear that we should NOT expect the Fed to keep blindly raising rates:

The FOMC will continue to monitor the incoming data closely to assess the prospects for both growth and inflation. In particular, even if in the Committee's judgment the risks to its objectives are not entirely balanced, at some point in the future the Committee may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook. Of course, a decision to take no action at a particular meeting does not preclude actions at subsequent meetings, and the Committee will not hesitate to act when it determines that doing so is needed to foster the achievement of the Federal Reserve's mandated objectives.

So much to think about in that little paragraph. But first, a recap of some central features of the Fed’s expectation of economic activity in the back half of this year:

1. A cooling housing market will weaken household’s resolve, or at least their ability, to sustain the recent pace of consumption expenditures.
2. Continued job creation and solid investment spending, however, will cushion the economy from the negative impacts of a housing induced consumption slowdown.
3. Strong productivity growth and intense competition will hold inflation and inflation expectations in check even as the economy edges up against capacity constraints. The capacity constraints should ease later this year as the economy slows under the force of point #1 above.

Given that this is how the Fed expects the economy to evolve in the back half of this year – an expectation based on the lagged effects of monetary tightening already in place – policymakers want to hold up at 5% to see if this indeed is how the economy evolves. The trick for the Fed watcher is to determine how incoming data will affect the Fed’s outlook.

My sense is that market participants (me included) have been somewhat underestimating the Fed’s resolve to bring policy to at least a plateau (again, refer to the flip-flopping in the fed funds futures market). For example, recent inflation data and rising energy prices appear to be having less of an impact on policy than I might have guessed. In retrospect, the lack of response is not such a mystery: There is simply nothing that the Fed can do about last month’s inflation. The point of inflation targeting is not to shift policy for every move in a lagging indicator. The point is to shift policy in response to changes in the central bank’s forecast of inflation. For the FOMC, the forecast for future inflation hinges more on the forecast for demand growth than on the lagged impacts of past inflation.

While that might explain the apparent lack of response to the March CPI report, what about the jump in new home sales, or the rebound in durable goods orders? On the former, the March sales report looks like the outlier among recent data; the trend still supports the contention that the housing market is cooling. Similar evidence can be found anecdotally in the Beige Book. The housing story is not reversed by one report. Regarding durable goods, the trend in nondefense, nonaircraft capital goods orders (note also the steady rise in backlogs), is solid but not explosive. Again, this is consistent with the Fed’s outlook. They expect cooling in consumption, not investment spending.

Policymakers also find support for the inflation under control story from the Beige Book:

Many Districts describe firms as attempting to raise selling prices but having mixed success, with price increases generally either smaller than the cost increases or less widespread. Richmond, Cleveland, and Chicago, for example, mention manufacturing firms' limited ability to recoup higher costs; Boston and Dallas say competitive pressures are constraining some price increases, and Atlanta notes that the ability to pass on cost increases varies across firms, depending in part on the strength of demand and contract arrangements…Wages continue to move up, but only a few Districts--New York, Dallas, and Kansas City--mention a pickup in the pace of raises, while Philadelphia cites firms more often paying in the high end of salary ranges.

Housing is slowing, investment remains solid, inflation looks contained with only one errant report. The reality seen by FOMC members appears pretty close to their expectations. Why not hold up at 5% to see if the consumption spending follows in line with the housing slowdown?

Simply put, Bernanke & Co. have faith in their models of economic activity. Not just a little faith either. Faith enough to pause even if the “risks…are not entirely balanced.” Again, Bernanke is warning that the continued use of this phrase in the FOMC statement does not guarantee future rate hikes. But he is also placing a bet – a big bet – on the economy. The risks are balanced toward inflation – there is no shortage of warning signs in the Beige Book:

While Cleveland's [transportation] contacts continue to express concern about fuel costs, many now believe that they can increase their base rates, given the strength of demand.

Production capacity for mining equipment in the Chicago District is reportedly booked through 2007.

The commercial real estate outlook appears to be predominantly positive across the reporting Districts--none report weakening commercial demand.

Dallas, Kansas City, and San Francisco contacts see little or no excess capacity in the energy sector. In particular, Kansas City contacts say that shortages of equipment and workers are constraining drilling activity; pipeline capacity is also limited in some areas. In the Minneapolis District, almost all open mines are producing near capacity.

While no District reports that cost increases have intensified in the latest survey period, Kansas City says that firms were having greater difficulty obtaining steel and aluminum.

Services firms are also reported to be facing higher costs, notably for utilities, shipping, and transportation.

Many of the pressures do not appear to be letting up. Oil solidly pierced the $70 mark, and metals continue to make new highs. Retail gasoline prices are over $3 per gallon in many areas weeks before summer driving season. The job market looks to be holding strong. But the Fed does not appear to be overly concerned about these trends – and not without good reason. Rising commodity prices and tightening labor markets are something we have been living with for some time, and the pass through to core inflation has been minimal. And one can argue that while rising commodity prices are a signal of strong global demand activity, the lack of inflation is evidence that the growth is not excessive.

Of course, one can also argue that the lack of pass through reflects appropriate monetary policy – slow but steady rate hikes on the part of the Federal Reserve. Will the rosy inflation outlook continue to hold if the Fed eases off the break? It’s not like the rest of the world is tightening policy at a breakneck pace. And is it really all that wise to bet against the American consumer? Lenders are working overtime to keep consumers borrowing (WSJ subscription).

The willingness to pause even if the “risks…are not entirely balanced” also suggests something about Bernanke’s view of the costs of missing the policy mark: he views the cost of accelerating inflation as less than the cost of excessive slowing. Or the magnitude of the latter error would be greater than the former. A case of once bitten, twice shy, considering the Fed’s underestimation of the slowdown in 2000? Alternatively, he might feel it is easier to correct for an inflation overshoot than a growth undershoot. I am confident that the blogging community could debate this topic for weeks to come.

A cynical person might suggest that a Bush-appointed Board of Governors is simply not all that interested in hiking rates as we approach the November elections, especially given recent polling data. Luckily, I am not a cynical person.

No, I am an optimist. Monetary policymakers see signs of slowing in the housing market, they do not see excessive growth elsewhere, and inflation looks contained. They are comfortable with – and not easily swayed from – the idea of pausing a 5% to see if overall activity does ease as expected. They want to make clear their inflation vigilance while making a bet that the slowing will occur before inflation creeps into the system. They are walking a tightrope. I wish them good luck, content to watch for data that either strengthens or threatens their resolve to pause.

Comments

[NinjaPlease]

So they recognize that the housing market is cooling off, but they STILL don't see the decoupling of productivity and worker's wages?

Hell the decoupling has been going on for twice as long as the housing market boom.

Job Creation will continue? May as well have said the Earth will continue to rotate in space for the latter half of 2006. How about specifics on job creation expectations?

[Johnson]

If I was Bernanke, I would be very very concerned about 1st quarter GDP, almost feels like 2nd quarter 2000 GDP numbers. Did it just crest?

[Emmanuel]

Very informative post as usual by TD. Other commentators seem to be making more of the rise in capital expenditures, though. A prolonged increase in CAPEX, which so far has been rather restrained, might help pick up the slack from an expected slowdown in consumer spending. It'll be interesting to see if this was a one-off event or a continuing trend.

[calmo]

Tim, the optimist, not the cynic.
Do you believe him? [Maybe it's only me, but this always sounds like an invitation to me --like those who will proclaim their conservative or liberal bent to others. They do not risk the chance that we will get the wrong impression. No, they tell us point bank: ' I am a conservative' and defy us to prove otherwise, or maybe handle any 'red or blue' ambiguity in a 'red' manner. I always feel that they could leave the marketing out of it; that there are other colors maybe; that darn it, let the reader judge this forchrisake.]

So I don't think Tim is an optimist.

Not a cynic either. But I do admire the thoughtfulness and care which he takes over these missives from Bernanke and the FOMC.
Ok, the tight-rope walker putting Bernanke & Co on a par with Evil Kinevil, was (like this) a tad histrionic:

They want to make clear their inflation vigilance while making a bet that the slowing will occur before inflation creeps into the system. They are walking a tightrope.

And we can only guess at how many numbers these people look at to pine for something, anything more dramatic.

Emmanuel is right about the CAPEX jumping up but the real worry has to be the lackluster wages that may slow with the housing. Inflation spiralling out of control from a bleed through in energy pricing is a scenario from the 70s when unions and workers had power, not 2006. The 'inflation creep' looks fairly diluted to me from this modern global perpective, but then I'm a pessimist, a real worry wort.
Trust no other reports.

[Tim Duy]

calmo - always pushing for a little more clarity...I imagine that deep inside I tend to be somewhat pessmistic. I tend to think that a price will have to be paid for what I tend to see as a multi-year global liquidity binge. But I try to keep the pessimism under wraps because, as you suggested, wage bargaining power appears minimal. Moreover, excessive pessimism (or optimism) is a sure way route to failure for a Fed watcher.

[anne]

Actually, if there has been a multi-year global liquidity binge then let's have more for the binge has led to as robust and stable a period of global growth as I know of. Life has likely bettered for more people in the last decade than in much or all of the last century. Ah, for liquidity.

[Winslow R.]

Just some quick thoughts, that may make no sense unless you look at the fundamentals of an inverted yeild curve.

If you look at the mechanics of borrowing short and lending long, a lot of long lending has been set in place at close to 5.5% for 30 years (my loan).

Technically to invert the yeild curve the current short rate inverts with the current long rate.

As long as the yeild curve has a positive slope, even if past lending becomes unprofitable, banks etc can still remain profitable because they can make new loans that compensate for past mistakes.

If the slope is only slightly positive the amount of loans needed to compensate for past loans is enormous.

This is only possible to stay profitable if current loan growth increases at a pace that can provide additional positive cash flow to compensate for the negative cashflow.

I think Bernanke after raising the ff rate 3.75 points is already making past 15 year loans unprofitable and will soon make past 30 year loans unprofitable.

Things get interesting. Currency rates are continuing to fall.

[calmo]

Now anne is a true blue optimist, even a deep inside optimist. [I'm sure this is just going to invite a column of Vanguard stats or a flock of birds --such is the depth of some optimists.]
Meanwhile, that CAD and trade deficit continue to grow waiting for interest rates to rise so that we can really feel what it's like to service this dept. [This is my gray sky people, not blue, not even a trace of blue --indicated by a slowing in these deficits.]
It's just so nebulous, this economic abstraction 'deficit', we only put wrinkles on our foreheads worrying about it --setting ourselves up for the birds. How about disposable income distributions that might be a little less nebulous? The lower eschelons may sink with the slowing of the housing market and this could be a surprisingly large portion. Cagan thinks otherwise --but he's an optimist, maybe a professional one, who knows like Tim that "excessive pessimism ... is a sure way route to failure" for a real estate economist.

[outsider]

Ben Bernanke is the only candidate who never crossed George W. Bush..,the other candidates expressed views about torture etc, that guaranteed their dismissal from consideration. W. visited Bernanke to congratulate him in his new position, a near precedent. Only happened one or two times in U.S. history.

M-3 money measurement has been "obsolesced", Inflation helps the incumbent party.

Want to bet that housing will be sacrificed before the November elections?

I won't.

[Robert]

Actually, if there has been a multi-year global liquidity binge then let's have more for the binge has led to as robust and stable a period of global growth as I know of. Life has likely bettered for more people in the last decade than in much or all of the last century. Ah, for liquidity.

I am no puritan. I enjoy my drink, ocassionally to excess. Great times, lots of fun, blah blah blah. And once in a great while, to extreme excess (though these days are probably past me forever). I even know a great place that makes a stiff life-saving Sunday-morning Bloody Mary (w/ freshly grated horseradish!), that takes the edge off better than anything I know. Yes a bit of "the hair of the dog that bit you" works fine. But never in my most debauched dreams would I ever contemplate a continuation down this most obviously self-destructive path. I believe there is no difference with liquidity as correlation of liquidity and recent progress doesn;t ,imply causality. The recent development progess and "achievements" of mankind can be reasonable attributed to many other things (end of cold war, changes in structural policies in China, India & other developing nations), technoplogy, productivity gains etc. Ascribing this to "liquidity" just seems plain wrong, and dangerous, and gives sustenance to voodoo Bush-o-nomic demagoguery...

[anne]

No; I am not being smug, but my rule in monetary is let the market show the way. The market has shown that international and domestic growth have been sustained through significant shocks while inflation has been limited. So, what's not to like in our monetary policy?

[Robert]

So, what's not to like in our monetary policy?"

What I believe economists and citizens interested in sustainable economic policy should dislike in our monetary policy is that it enables and encourages inflation concurrent to Asian CBs manufacture of liquidity as if it were going out style, US & Japanese Fiscal policies creating liquidity at unsustainable and injurious rates to future growth; as a result contributing to an unsustainable trade account, and unsustainable current acocunt position; enabling and encouraging rises in Asset Prices that distort market signals throughout the economy; encouraging imprudent risk-taking (by historical comparison) with respect to quality, quantity, and pricing of leverage; for a start.

I realize that many of these are not the fault of the US Federal Reserve at source. But Fed policy is not made in a vaccuum, and to encourage negative real interest rates in the context of these coincidental drivers contrary sustainable policy has been reckless and re-distributed wealth from savers to speculators. The Fed is singularly placed with the vision & power and lack of electoral pressure to weigh the relative push & pulls of all the global factors and set policy accordingly. Five years of being massively behind the curve will IMO have negative consequences above and beyond it's temporary contribution to (and probably mis-attributed) current feeling of well-being.

[calmo]

Outsider slaps me with this:

Want to bet that housing will be sacrificed before the November elections?

and I admit to not giving this a political thought: the advance of mortgage rates through the 25bp increments is not merely an effort to control the housing market, but a threat to Republican hopes in the coming Nov elections.
Greenspan had told us that those at the margin were small in number and that increasing the rates would not be a hazard for the prudent (non short term ARM) home buyers. [The harvest/sacrifice would be small, but necessary --to keep those prices stable (except for houses, commodities, energy...).]
If housing stats show a bulge in volume/price and Ben still sits at 5%, I will think that the rate may be slowing down for political rather than economic reasons. (Seriously I can't think that W and Ben have anything in common beyond their GOP membership and so any visit is W's option and Ben's burden.)

[anne]

Robert, I appreciate your argument, for it is flexible, but there is just no evidence that liquidity expansion through central banks has done anything other than spur sound international growth through a decade in which shocks might have easily made it otherwise. Be careful before adopting a no pain, no gain approach to central bank money management. Still, even with your caution an international portfolio has been called for emphasizing stocks.

[a]

calmo:
Seriously I can't think that W and Ben have anything in common beyond their GOP membership and so any visit is W's option and Ben's burden.

When asked about tax cut or spending cut, to reduce deficit, BB's answer is that the congress should decide how to reduce deficit, and tax raise can reduce deficit too. He refused to give support this way or other. Somehow I like it. I found most of his testimony reasonable, nothing even remotely close the GW's ideological stupidity.

But then if he is pausing to help the mid term election?
Or helping speculators robbing savers (I found it a hard assumption to swallow)?

As for the saver, if there are many at all, they should not keep cash in the bank, and if they put their savings in a fund that is based on the market, they should be fine with inflation. I also tend to think the savers that would be hurt much are in small numbers today, with negative household saving rate.

[anne]

Precisely; Ben Bernanke does not have the conservative bent on fiscal policy that Alan Greenspan had other than a wish that we might have more of a budget balance. The monetary policy reading will be an attempt to allow growth to the point of increasing inflation, but to control inflation, and we are near a point where the Federal Reserve may pause in tightening and notice price movement while accepting robust growth.

[anne]

Think carefully how to set a portfolio to realize relatively attractive valuations while being suitably cautious, remembering how attractive investing has been. Grumble away, but think how to invest.

[anne]

Notice the mix of Vanguard funds through this period, because through all the worry cautious investors have been part of a wonderfully broad and deep international bull market yet many have not noticed. The extent of the bull market through developed and emerging markets in domestic currencies and dollars has been wonderful.

[calmo]

If anne isn't being paid by Vanguard she should be. Vanguard is so wonderful it almost makes me want to take up Roach [yes, just for balance, less for sport] and his latest missive about how the G7 have finally seen the light and now it's time for "the heavy lifting". [I don't make this up people.]
I can just see those mighty lead pencils at work, you?

[anne]

http://www.calvorn.com/gallery/photo.php?photo=5297&u=17|9|...

Palm Warbler
New York City--Central Park, The Pool.

Calmo, what a pleasure to read you :)

[me]

"Continued job creation and solid investment spending, however, will cushion the economy from the negative impacts of a housing induced consumption slowdown."

The only hiring has been in construction. If construction slows down, why would employemnt go up, especially when the firings have begun in the finance-construction related industry?

[a]

"Grumble away, but think how to invest."

I have listened to Anne.
I have some cash in the bank, not much stock holding, and no mortgage and own no house/apt, etc. I am the saver here, as typically we Chinese save. I start to buy some stock myself recently. And I am fully aware that inflation could devalue my saving into "nothing". (luckily, rent has not gone up a bit since 2001 in NYC)

I think anyone who missed the housing boom, for some reasons, should not feel bitter about it. It is for everyone's interest that housing market does not crush --- as "me" also mentioned, financing-construction sector has been major driver of economics in recent years. Most of the home buyers are not speculaters. Most of people bought houses to live in it, last time I read in the newspaper, investment property is no more than 10%. In counties where housing price surged, that percentage goes up to 20%. So majority of people buy houses to live in.

That is why, framing the issue as "savers" vs "speculaters" is wrong.

[calmo]

I feel a certain impulse to react to this:

Most of the home buyers are not speculaters.

not because of recent reports (which may be dated now)[seriously, other more recent reports show that the top earners have diversified out of US real estate] (While I type they could be piling into commodities, but for this mission, I consider my message, however dated, is worth your attention.)
In 2005 (yes that long ago, forgive me) fully 40% of sales were multiple house owners. So 'a' is right, most buyers are not speculators by this metric. But a record number are, as RE has been 'the driver' and the only serious speculation in this economy since 2000.

I'm sure this is just my reaction to being accused of being a pleasure to read and know that my need to be an aggravation is suffering terribly.

[Robert]

Anne said:

but there is just no evidence that liquidity expansion through central banks has done anything other than spur sound international growth through a decade in which shocks might have easily made it otherwise

'Spur international growth', it has done! The soundness of the growth is, however, the focus of my derision, and my difference with your sanguine view. Though I will admit to you, Anne, that I take issue more with what I see as as mindless, politically expedient, fiscal policy (& Nippon ZIRP), than the Fed. BUT, I trust you too will admit that it is difficult for the American political process (as well as most democracies) to police spending, though more importantly to police the different between spending & revenues. Opposition must first educate and explain, then re-hash both sides before assasinating the opposing view and proclaiming why theirs is better. The demagogue has it easy. He need only pander to the LCD for they WANT to believe in faerie-tales, that the impossible is possible - all the more imperative when elections run every two years. So who's left to help "the people" understand what is in their interests in reagrds to something as boring, obtuse, and technocratic as fiscal policy & deficits? Brookings? AEI? FOX News? Hoover? Harvard? The Wall St Urinal? Prof Thoma? (no disrespect to the good Dr. intended). The obvious answer (to me) is that the Fed is the only ostensibly independant and objective body with power that has a rat's chance in hell of preventing the absurd and the ludicrous from inertially becoming the patently dangerous - economically speaking, for it is one of their dual objectives ("price stability"), clearly so stated in their charter.

I realize this takes me back to Roach-ville but the growth IS, and has been, unbalanced; fiscal gaps cannot continue; CA defs and trade accts ARE unsustainable. The more we go down this path, the more we either borrow from the future, or redistribute from savers to borrowers with all the consequential allocational impacts along the way. I vilify the Fed NOT for creating it, but for facilitating and enabling it with their duplicity, when their instructions are as clear as bi-polarly possible. It's obvious to most economistse that we can't continue as such, yet they do little to facilitate an orderly adjustment sooner - one that everyone knows is coming - opting instead for the larger and probably more dis-orderly adjustment in the future. I wish I wish I wish had the knowledge and wisdom to develop the econometric linguistic to lay out a more numerical and precise cost/benefit equation, but unfortunately this will possible for forensic economists only with hindsight.

[anne]

Oh, you are justified in complaining for fiscal policy is a distinct problem that the Federal Reserve must work around now, but think back a few years ago when responsible fiscal policy could have if not retired most public debt this decade then readily left debt growing no faster than the economy grew and that is enough for responsible policy. The Fed however is not a legislative institution; that is Congress.

[Robert]

It is not a stretch to suggest that FRB's mandate bestows upon it, a well-researched & wise technocratic check to balance the flaws inherent in our (and other OECD) democracy. I am not asking it (nor expecting it) to legislate (adhere to Issing-like rectitude), but like the Supreme Court, it has the ability to exercise a de facto veto where legislated policies are inimical to FRBs raison d'etre. Failure to exercise its "veto power" - by insuring real rates remained negative for 4 years concurrent to yawning fiscal gaps (and Asian spigots wide open) cannot fail to have negative repurcussions for years to come.

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