Here is Tim Duy's latest Fed Watch:
Ascendancy of the Hawks, by Tim Duy: My time of capitulation has come. After the weak labor report, I would have thought a pause in at the next meeting a sure thing and played down the comments of ultra-hawk Chicago Fed President Michael Moskow. I was even bold enough to say as much to a reporter:
"I do believe there is a building argument for a pause," Duy said. "The Fed could take a breather and wait until we see how things play out."
Since then, however, the din of Fedspeak has become deafening, and it speaks a single message – look for yet another Fed rate hike at the end of the month.
The Fed finally found what it has been lacking, a consistent voice. Or at least we can only hope that a consistent voice has been found, and that Fed Chairman Ben Bernanke can stay on message. For a terrific summary of Bernanke’s flip-flops, see Liz Rappaport at TheStreet.com (thanks to Barry Ritholtz). Of course, not everyone views recent Fed speak as flip-flopping. David Altig at macroblog argues that from his view point, FOMC members have been true to their word, but the data have been pulling us in different directions. See also Jim Hamilton and Brad DeLong. Their position argues that the confusion stems from the pundits’ attempt to pigeonhole Bernanke; I disagree, but will pick up on that issue in a later post.
In any event, the Fed promised us data dependency, and no one can argue they didn’t deliver, but, as I have argued in the past, they left out something critical: They simply failed to inform us about their underlying economic model. In other words, market participants were unable to grasp the implications of incoming data as far as it affected the Fed’s economic outlook.
The problem was of course worsened by the inclusion of an economic forecast in the May 10 FOMC statement:
The Committee sees growth as likely to moderate to a more sustainable pace, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.
This appeared to raise the importance of demand pressures in the Fed’s forecast. Hence, the sharp fall in expectations for another rate hike in the wake of the employment report. (What I don’t yet understand is why the FOMC felt compelled to add this outlook when at least one policymaker was recommending a 50bp hike at that meeting. One contact’s explanation is that Bernanke made the slowdown call too early relative to the preferences of other FOMC members.) That response, however, was apparently too much for policymakers to stomach, and they came out in force, with Moskow followed by Bernanke, Governor Bies, St. Louis Fed President William Poole, and Governor Kohn. The message: When we said data dependent, we didn’t mean all of the data, we meant just the inflation data. More seriously, David Altig succinctly summarized the message for us:
To paraphrase, yes we are pleased that the recent levels of measured inflation have not unmoored the public's belief in the FOMC's commitment to price stability. But yes, we also realize that the recent inflationary experience is not consistent with those beliefs -- or the Committee's own objectives -- and we do not take our credibility for granted.
In short, those of us drawn into the direction of a pause (see also Caroline Baum and John Berry) followed the increasing Fed chatter proclaiming the forecast for slower growth, assuming it was a signal from a new Fed Chairman known to be a proponent of inflation targeting. In this, two mistakes were made. The first mistake is that even if this was what Bernanke had intended, he does not have the political capital within the FOMC to carry out his will. He is not Greenspan. The second mistake is more fundamental: Barring clear evidence that the economy has rolled over, central bankers will always weigh incoming inflation data over all other data.
In one sense, I am pleased that the Fed was willing to actively and consistently reset expectations. After all, apparently I have been quoted as saying:
In the end, the vote of the rate-setting committee might still be unanimous --- to protect the institution's credibility --- but the ongoing dissension is "unsettling," Duy said. "I can't tell how they are interpreting the data. It doesn't seem to be interpreted consistently."
Of course, this implies I see various camps emerging in the Fed. This was evident in the minutes of the May 10 meeting, with opinions spanning the range of no hike to a 50bp move. And I have already commented on previous dovish statements from Kansas City Fed President Thomas Hoenig. He repeated these thoughts last Tuesday, but he was largely drowned out by the inflation chorus. From MarketWatch:
"As the economy moves back towards its long run potential (growth rate) of 3.25%-3.5% ... then I think inflation will taper off as well," Thomas Hoenig said in a speech to a business group in Denver.
"I think it is frankly too early to tell whether we are being behind the curve," he said. "We have only recently moved interest rates to the 5% level. We know monetary policy acts with a lag. We know that those effects will still be months ahead of us."
No, Hoeing is not committed to another hike, and probably wanted to pause at the last meeting. Is anyone else at the FOMC starting to feel queasy about blindly hiking away? Note that three District Banks – Kansas City (Hoenig), Philadelphia, and New York – wanted to keep the discount rate steady last month. Counting votes, however, is simply an academic exercise at this point, especially now that the Moskow-Bernanke-Bies-Poole-Kohn contingent has effectively moved the markets in that direction. Indeed, I think it is hard to back off another rate hike at this point. And the tough talk implies that rates will stay high for longer than expected. I can’t imagine that Fed officials will easily back away from a hawkish stance after so effectively flexing their collective muscles. But what if the next round of inflation numbers comes in below expectations….?
New York’s interest in holding the discount rate steady is intriguing. Bank President Timothy Geithner’s position puts him in steady contact with global financial markets, and one wonders what he is hearing. Financial market participants look to be reevaluating their appetite for risk, especially now that the Fed is being joined by a chorus of other central banks – in addition to the ECB, the central banks of Turkey, India, Korea, and South Africa all tightened. Global markets have swooned, and the yield curve in the US has slipped into inversion between the two year and the ten year Treasury rates. If the long end doesn’t starting selling off over the next few weeks, the Fed is setting itself up for a significant inversion.
But what exactly does the ever so slight inversion of the yield curve mean? Back, once again to the bond market conundrum. Is the Fed – in concert with other central banks – poised to tighten too aggressively? I had hoped not. The economy looks to be easing on the back of a slowdown in consumption, but core investment spending appears solid and the slowdown should ease inflationary pressures. By in large, this looked consistent with the Fed’s outlook, and suggested that a forward looking central bank would pause. But the Fed has made clear it has other plans, and now I am picking up a considerable amount of uneasiness from various contacts. And experience has taught me to pay attention to that sense of unease. Experience has also told me that the Fed will not pay attention to that unease, as a read of the 2000 transcripts will make pretty clear.
Of course, an expectation that the Fed would not go too far may have been simply naïve. One contact simply noted with a sigh, “But they always go too far.” What will drive them to go too far? We can start making a list:
1. Fed officials on average will discount financial market signals. They don’t have faith that ups and downs of the market are anything more than up and downs. They will argue that there are too many false signals in financial market data, and they dismiss concerns about the yield curve.
2. Fed officials will discount the impact of the housing slowdown. The focus on housing we saw last year appears to have reflected Greenspan’s views. I should have picked up on this earlier. From MarketWatch: “Poole said the financial press puts to much focus on "highly visible" sectors like the housing sector, even though it only amounts to a small fraction of overall GDP growth.” The Fed discounted the impact of the NASDAQ meltdown as well – technology was thought to be too small a part of the economy. The housing slowdown will be even easier to discount, as it will happen in slow motion.
3. Talk of inflation targeting aside, Fed officials will place a high weight on current inflation numbers. Even if the numbers this week look tamer, the hawks will fixate on the last two months of data.
4. Fed officials will want clear signs in the data before they acknowledge that a slowdown is actually underway. It can take awhile for such data to build. Economists, me included, are prone to this error.
Do I sound somewhat pessimistic? I would rest easier if the economy didn’t look to be slowing, or if experience had not taught me to be wary of asset market (in this case housing) reversals. I would also feel better without the ascendancy of the hawks at the FOMC. Time will tell, but with growth moderating, I am not seeing the inflation threat. The slowdown in nonfarm payrolls eased my mind considerably – it seems unlikely that inflation will get out of hand without considerably higher nominal wage growth than we are seeing. Nor did the last reading on productivity suggest an inflationary surge is at hand:
Click on graph to enlarge
Bottom line: The Fed is poised to tighten at the end of this month. It is not clear how they would interpret lower than expected inflation numbers over the next two weeks – hawks may view them as anomalous given two higher than expected inflation numbers. In any event, they will leave the door open for future rate hikes. Note further uncertainty in the speaker schedule – we hear from Bernanke alone three times this week. Can he stay on message? The financial markets are struggling to grasp the implications of the ascendancy of the hawks – and concerns that the Fed will soon overtighten should not be ignored.
I'm sure Tim would appreciate hearing your thoughts. Update: Brad DeLong comments on Tim's view of the Fed's hawkishness.