Fed Watch: Ascendancy of the Hawks

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.

Comments

[dWj]

Supposing this is mostly Bernanke's show, his incentives early in his first term are to lower inflation expectations and to build hawkish credibility. I think those expectations are more important to him than current inflation itself.

[save_the_rustbelt]

This amatuerish bumbling hurts real people.

[Robert]

Periodically shaking-out leveraged speculators to tame animal spirits is an under-appreciated policy tool in itself. This is not to be confused with "jamming on the brakes too hard", but is more like "pumping the brakes" which sends a strong message to anyone tailgating that this is not a wise pursuit. That the markets have reacted so skittishly to intimations that the FED might not take a pass says (to me) much more about markets themselves, quantities of speculative assets, and the general diminuation of participant horizons & perspective.

[dryfly]

Periodically shaking-out leveraged speculators to tame animal spirits is an under-appreciated policy tool in itself.

I think Robert is on to something - I think the recent market swoon tells us more about the market than it does about the direct effect of the FED & rates.

I am increasingly running into equity fund buyouts of small to medium manufacturing companies. These are the mfg companies I sell to, I sell for, and I compete against.

These equity funds pool money from wealthy investors & retirement funds (etc.) then leverage it with loans from banks (or the likes of GE Capital)... Then use the money to 'pimp' the manufacturing company (upgrade capabilities & expand market access if not domestically then by taking their proprietary technologies to Asia & expanding there)... Finally they 'flip it'... sell the pimped out companies for a nifty gain. I was informed that over the last few years this practice has greatly out performed the 'general markets'.

I use the word 'pimp' because it reminds me of the cable TV shows where they take Mom's old mini-van and 'pimp the ride'... turn it into a rolling penthouse. Looks great but is still a mini-van... similar thing going on with many of these equity firms & their acquisitions. Companies are dressed to sell but still make widgets.

Anyway it became clear during this meeting how susceptible these equity firms, their lenders & even acquisitions are to interest rates... every bump makes the hurdle higher... the more they leverage the acquisition, the more sensitive they are to interest.

From what I was told there is a lot of money out there like this and they are all very jumpy - and ought to be. My guess is other businesses outside of mfg are just as 'operationally' sensitive to rates and equally jumpy.

To steal Roberts analogy these folks are all tailgating the rate curve and very closely. If the traffic stops there will be quite a pile up.

[calmo]

The old Fed worked like a colonial department with a Head rather than a Chairman listening (imagine that people!) to the other members in a civilized democratic forum.
By and large (I stamp out all varieties I don't like --so colonial.), it is our problem to adjust to real intelligence having spent close to 2 decades with something less.
I can see that a continued drop in the DOW, no matter how irrelevant that may be to 'the incoming data', will exert pressure on the Fed to pause. The inflation threat seems dwarfed by the bite that fuel costs are taking out of wages. The housing picture behaving pretty much (by and large, ok?) as watchers have expected. So I'm leaning on a pause if the DOW sinks below 10,000 and/or housing really craters

[Winslow R.]

It is looking more and more like the brakes are not being pumped but actually being slammed. Not something I expected from Bernanke. Loan growth was still very strong 1st quarter (11%) and month May (18%) though the latest volatile weekly (8%) numbers show loan growth may be slowing and the yield is very slightly inverted.

Calmo writes so clearly at these late hours. You have company with your prediction in on the Dow. We've had O'neill from commodities, Snow from transportation and now Paulson from the financial sector. Though last time we had a financial sector guy the Dow did pretty well.

[calmo]

Good evening Winslow and thankyou for finding something clearly written in my post. [Where?] I don't think we will be better off with Henry (anne knows him to be a birder) [Could be he's the same kind of birder that Cheney is --a big shot birder.] and possibly at some risk.
Yes, Harriet would have been a better choice: just get the slide overwith and start over with the Bull market optimism we so desperately need. Nano tubes, Martian real estate, we won't care.

It is looking more and more like the brakes are not being pumped but actually being slammed. 25bp, Win, is not a slamming of the brakes, but a continuation of the tradition of 16 other non-slamming and honestly, pretty ineffective braking.

[anne]

Actually the Federal Reserve has been remarkably successful through this sequence of short term interest rate increases. The economy has grown well through strains, and there has been only a minor gain in inflation that can be limited from here. Long term bond yields are low enough to tell us that long term inflation is considered no meaningful risk. What is interesting is the absolutely flat Treasury yield curve, with yields almost identical from 6 months to 10 years.

[anne]

That the Fed has managed so well, given our terrible fiscal policy and war and energy price increases is an assurance.

[Robert]

Tnx Dryfly.

To be be clear, I wasn't implying that 25bps here or there is akin to pumping the brakes, rather that tightening when not expected to tighten is the thing that keeps speculators on their toes. The BuBa was masterful at intentionally NOT fulfilling market expectations (at least in respect of timing), for this express purpose.

In a perfect world, the Central Bank would be able to explicitly and transparently make it's policy known, and markets would adjust accordingly. But in the world in which we live, markets and speculators can (and do) get of ahead of policy and market expectations, frequently ignoring explicit policy statements, or try to "game" the politics surrounding future policy, which resembles a form of free-rider parasitism that bet's upon policy asymmetrically skewed towards growth regardless of diminshing returns (i.e. future costs) to monetary laxness.

There really are few ways to combat this moral hazard other than periodically tipping the cart of expectations (which is different from tipping the cart itself). One may dismiss these free-riders as 'inconsequential' or 'necessary to tolerate' for the sake of "greater growth", but they really represent the vanguard of future representative behaviour, and if left unchecked - whether for political expediency, or other - will yield to poorer price signals, more inflation, and /or bubbles, than would be case if the free-riders were checked more frequently.

[slink]

very nice comments

fed watch is not my idea of fun

but let me throw this out

with all the tilt toward transparency

and in this case
a macro model we all understand
directing the actions of the fomc

ain't there something to be said
for policy uncertainty
an unpsychable fed

maybe not a madman fed

but a loosely "geared"
policy head at fed
keep em guessin'

might be a plus

asset markets are so very diff
from product markets that way

[groucho]

"One may dismiss these free-riders as 'inconsequential' or 'necessary to tolerate' for the sake of "greater growth", but they really represent the vanguard of future representative behavior"

Robert, I quant understand what you're talking about.

Didn't you mean to say "three cheers for the financial engineers"..... or as W use to say "Bring em on!"

[Robert]

Amusing anecdotes abound about how the Soviets perceived Reagan as wacky, unpredictable (amongst other things), never certain about what he might do next, which was not without its attendant cold-war policy benefit for the US, even if inadvertant).

Imbueing this into Fed-act would have little impact upon real, long-horizon investment, nor impoverish labour, but it would keep the leveraged speculators awake at nights almost as much as a large portrait of sober, cigar-chomping, Paul Volcker hung over one's mantlepiece to provide a constant reminder to never to take US Monetary policy for granted. They are, after all, supposedly guarding something precious on behalf of the American people.

[Robert]

Groucho-

I was suggesting that there are apologists for Fed's lenient implied "put-writing" who discount the "moral hazard" of this activity(thereby rewarding the leveraged specs) arguing that they should tolerate this so that they do not damage the real economy, and thus labour. But this is short-termism, because IF there is a put,or more importantly if people believe there is a put, then what the specs are [rationally] doing today, "the people" will do in spades tomorrow. Until one day, we wake up and find many ordinary people have bought untold investment properties with some kind of inverse zero-amortizing balloon-rate-spread-adjusted floating mortgages that WILL undoubtedly have profound effects upon the real economy (and labour) when they sour...

[Winslow R.]

25bp, Win, is not a slamming of the brakes, but a continuation of the tradition of 16 other non-slamming and honestly, pretty ineffective braking.

Repetition; as the Fed repeats, I repeat my view. I see the Fed tool of interest rates as ineffective as a light switch. You can push on a switch but until you actually provide enough force to flip the switch, not much happens.

The yield curve is slightly inverted. The switch is getting very close to being thrown. Financial intermediation (loan creation) is the thing that gets turned on/off in this case.

In 2000, rates (10 yr, ff) inverted from June until Dec 2000. Loan growth turned negative in Oct 2000, 5 months before March 2001 the 'offical' recession start. Loan growth might be worth watching.

To use Robert's analogy, as the Fed attempts to shake the free-riders from the cart, they are getting very close to tipping the cart over. I did/do not expect Bernanke to do this but it IS happening.

Who would want a recession only 5 years past the last and right before the 2008 presidential election cycle?

[groucho]

"But this is short-termism, because IF there is a put,or more importantly if people believe there is a put, then what the specs are [rationally] doing today, "the people" will do in spades tomorrow."

Robert, you are a noble and honorable man for defending "the people" from foolish financial behavior.

But don't you think another game is afoot?

Globalization is mainly(except in the middle oil east)a financial structure of control. Don't you think the current power structure(Washington/NY/London)is more interested in developing financial skills that can be put into play around the world, than worrying about their own citizens financial health?
The fact that LTCM was bailed out but small fry shareholders of enron, worldcom, etc.. were left to their own devices seems to show where the objectives lie.

[Robert]

Winslow R

I agree with your analogy, but direct any blame squarely upon the admin and congress for their shameful neglect of fiscal policy, that's left the Fed few good choices. No one ever wants a recession except for the true curmudgeons. But if the last "recession" was shorter and sharper than it might have otherwise been without intervention, but the price of that intervention was a shorter-upswing since we've borrowed from the future, then so be it. While I personally think growth is better than recession, there is generally "price" for borrowing growth from the future. I

[Winslow R.]

While I personally think growth is better than recession, there is generally "price" for borrowing growth from the future.

You would still like to fight the 'old war'.

Ferguson’s framework left me pondering my own view of the world. I am quite sympathetic to his focus on breaking down globalization risks into two major buckets -- financial and political factors. Economists and investors tend to focus on the former and yet often go wrong because of the latter. I am very sympathetic to his critique of central banking; the old-war versus new-war analogy is a point I have stressed for a long time in voicing my concerns over the recent emergence of a potentially lethal interplay between asset bubbles and the debt cycle (my earliest comment on this can be found in an 11 October 1999 essay, "Sinister Twilight"). His concerns over risk are especially relevant in an era when spreads on some of the riskiest assets have been squeezed well beyond what history suggests is prudent. But in the end, I guess I worry most about the political backlash angle, and fear it could be worse in this globalization than it was the first time around.

Mr. Roach

http://www.morganstanley.com/GEFdata/digests/20060612-mon.html

[Richard]

Perhaps the game is even simpler.

To raise or not to raise is a marginal call. But to do so now, sharply, burnishes the credentials of an inflation fighter. And if there is a pause in a few months time, the market balloons upward just before midterm elections.

[calmo]

Richard notes the political timing is an important aspect in predicting the Fed's next moves. Which is why we have an independent Fed that is represented by both parties in nearly equal measure so that we (also independent, fair and balanced) don't get some clown like Clinton in again.
The mandate of the Fed is not revolution. But should present policies of the administration create conditions that foment civil unhappiness, possibly unrest (and the unstable prices and lousy employment that go with that), it may be an act of complicity to pause out of no other concern than to rescue government approval ratings. A pause, no matter the inflation meter, is a short term (possibly more) benefit to the consumer and a more agreeable voter.

[Robert]

I stopped reading his comments a year or so ago, but I am never embarassed to find that I've independently arrived to viewpoint that sees a similar endgame as Mr Roach. No one critical of fighting "the old fight" has been able to convincingly articulate how or why NOT fighting the old fight has ever had a happy ending, and why this time should be any different.

For the record, Groucho, LTCM wasn't 'bailed out'. Investors in their fund sure enough lost well nigh everything. 100%. There was no subsidy, graft in the NY Feds managed unwind. What the NY Fed did was effect was to prevent the run on OTHER banks, once the run on LTCM ran it's courseby providing temporary liquidity as a lender of last resort. This restored confidence, liquidity, and stability to the financial system and was both wise and prudent. I know this sounds like a PR release, but its the truth. For the skinny on LTCM, Lowestein's book (known affectionately as Merton's moan) is pretty spot-on.

[Anarchus]

One odd thing about developments of the past 4-6 weeks has been the contradictory behaviour of the stock and bond markets.

The equity market peaked on May 8th and if you believe the pundits, stocks have collapsed since that time because: (1) we've learned the Fed is not likely to "pause", and (2) inflation expectations have run amok. In contrast, 10 yr treasury yields peaked on May 12th at 5.19% and have now fallen under 5.00% as bonds have rallied. Over the 4-6 weeks the TIPS have barely moved, so the decline in nominal yields appears to reflect falling inflation expectations among bond market participants.

The only way I can make sense of all this is that the markets have decided that for whatever reason (short term inflation blip, too little surplus capacity in US labor and manufacturing, Bernanke's incipient fascination with all things Bartiromo) the Fed is going to keep tightening steadily and GO TOO FAR, thus provoking a recession, which exacerbated by high consumer debt levels and collapsing housing values could lead to a deflationary depression, or worse.

Or not.

This is of course completely contradictory to everything the pundits are claiming, but that's probably just white noise.

[anne]

Robert described well the need for stabilization of the LTCM portfolio. The astonishing leverage through derivatives of the LTCM portfolio was a threat to actual trading in the bond market so the Federal Reserve and Treasury sought to protect the bond market as they should. Always look for the Federal Reserve to protect the financial system.

[anne]

Anarchus describes the current bond market well, but why complicate the description? Long term investors are for the time assuming there will be no significant long term inflation, and 5% is a reasonable Treasury interest rate for long term bonds. The assumption is the Federal Reserve will easily be able to dampen inflation from here.

[Robert]

The fear is not the Fed itself, but the administration and its congressional toads pandering for votes by continuing its fiscal pecadilloes. What will the Fed do another $700 billion in-the-hole later in '06, yet another in $600 or $700billion '07 ?? Just tip out the gas can and light a match......

They will have no choice but to counter it and counter it vigorously. And it would have all the consequences you've foretold. On the other hand, rein in the spending or raise the revenues and outcome is the same. There are some who will say moderate inflation is the better outcome. But what happens when it slips into the severe as the Fed desires to continue walking the fine-line?

Pray for $25 oil. Pray for gangbusting growth everywhere else when the US pulls in its horns. Pray we don't slide into protectionism or competitive devaluations. Pray for leadership. Pray labour remains docile. Pray foreigners are magnanimous with respect to their treasury holdings. Pray for a peace. Pray for a continuation of Japanese ZIRP. There are a lot of prayers to be answered!!!

[Anarchus]

Hmmmm, we have nothing to fear but the fed, itself?

The problem with trotting out all the standard bogeymen and peccadillos as an explanation for the stock market collapse is that they were all there in January, February, March, April and May. Somehow, something sharp and nasty pricked the stock market balloon on or about May 8th and equities just haven't been the same since.

If anything, it may well have been the Fed meeting on May 10th after which it became clear that the much hoped for "pause" was unlikely to be forthcoming anytime soon.

[Winslow R.]

I stopped reading his comments a year or so ago, but I am never embarassed to find that I've independently arrived to viewpoint that sees a similar endgame as Mr Roach. No one critical of fighting "the old fight" has been able to convincingly articulate how or why NOT fighting the old fight has ever had a happy ending, and why this time should be any different.

Robert, your framework is solid though there are many fickle forces out there that can 'cause one to adjust to changing circumstances'. Making a call on what the Fed will do, is subject to too many variables at this point with the curve inverting. My guess is they do raise rates at the end of June, though if the long-term does not follow the FF up, there will likely be a subsequent rapid fall as in 98' but instead of LTCM it will be the American consumer. I don't think anyone wants a recession, even the curmudgeons.

[anne]

No; there is really no reason for long term Treasury rates to increase as the Federal Reserve raises short term rates from here. Bond investors seem confident that the Fed can readily contain any inflation from here, and I agree with them.

[anne]

Also, if long term Treasury rates stay about 5% there is reason to believe we can avoid a recession and look for growth to continue at a reasonable rate. No developed economy has gone to recession through this energy cost increase cycle.

[Robert]

Anne said
No; there is really no reason for long term Treasury rates to increase as the Federal Reserve raises short term rates from here.

There are many reasons for LT rates to increase: huge fiscal yawn & no attempts to fix; copious liquidity growth; Japanese ZIRP; Handbrake broke on the Chinese go-cart pegged to USD; waning confidence in US political leadership; expensive mid-east quagmire; petro-dollars sloshing everywhere; baton of bond ownership passing from Asian CBs to fickle Cayman hedgies; etc etc.

All which doesn't make it deterministic that long yields must or will rise, but its nonsense (and dishonest) to dismiss these with quite so much ease. They ARE rather serious potential determinants to the price of dollars bonds.

[anne]

Nonetheless, I have been hearing the same for too long to worry much about bonds. What impresses me is just how stable the bond market has been. China and Japan and the oil exporting bond buying countries do not worry me. Hedge funds? No. Paul Krugman worries, so I pay attention, but a 7% long term Treasury still does not seem near :)

[anne]

Suppose however that there were a shock from price index figures and long term bonds were to rise sharply. What then? Well, I have long been defensively positioned and assume professionals are for the markets have given value in defense. I trust the Fed response. Fiscal policy is a subtle long term problem, why should the consequences appear soon?

[Robert]

Yes, people have indeed been worrying since "the great leveraging" began in 1982. Perhaps people underestimated the debt capacity of our economy. Perhaps they underestimated the impact of longer-term moderate inflation and higher real growth upon the nominal value of cumulative debt. I am as gulity as the others, mea cupla. Compound real growth is a powerful thing, and easy fail to fully appreciate.

Maybe this "magic" will be repeated, and further meaningful real growth will be conjured which, along with continued moderate inflation will, once again whittle the nominal values away without a derailment. But inflation has a long seductive legacy, and like alcohol or other addictive intoxicants, many who get entangled find its their undoing. Though I think ultimately all roads will lead to a more meaningful contraction, I am not arguing for which road we'll travel - just that this ridgeline we're navigating has become steeper and more precarious as time has passed - not deterministically, but from impatience and political expediency. Keeping upright is increasingly a less stable state, with diminishing marginal returns required to stay atop. Now, we find ourselves having lost our harness & ropes, low on water, no sterno. We've emerged intact from previous scrapes, but chasms on either side of the ridgeline (towards inflation or deflation) are more steeply sloped than ever before. There's still time to go back, fix the fiscal side, but failing that, it's a long way down- either way.

I still have some trust in the Fed too. But an unrepentant admin and congress and a fed that will respond traditionally to increasing inflationary pressures is an ugly scenario given the amount of leverage in the system, even if they appease political critics and remain a step or two behind the curve.

[dd]

Robert, an interesting analysis and insight into the connundrum that should not exist and the duelist nature of long term rates presupposing both recession and contained inflation confusing a confounded bond landscape. The ridgeline is indeed narrow and the slopes more derivatized making the risks much sharper. Perhaps it was the choice of risk's champion Paulsen that transformed Bernanke's dove into an inflation fighting hawk.

[dryfly]

Nice analogy Robert - the ridgeline - I've hiked more than a little myself. I could see the image.

What's worse is the image of the 'intoxicants'... When I was young my buddies & I used to hike with a big bottle of Tanqueray. Nothing quite like a Gimlet buzz at sunset overlooking a glacial lake at 10,000 feet. However that ridgeline trail back to the basecamp, in the dark, becomes even more precarious then.

That's the analogy I think best fits our current situation - precarious as hell but who the F cares, we're immortal right?

[zink]

Following the last Fed meeting, just several weeks ago, Dr. Bernanke and several Fed president's suggested strongly that they were considering a pause. The speculators went crazy. Oil shot to 75 big one's per barrel, as everyone scratched their heads and commented that crude inventories were ample - why the run up?

The base metals continued their maniacal verical price levitation as the fund money pounded anybody and everybody with a contrarian thought. Gold set a 16 year record, and silver for goodness sake, shot vertically upward.

The dollar swooned, with every indication the long awaited crash was at hand as forex traders showed who was in control, sniffing haughtily at the boy at the Fed.

The only partial restraint was a rise in yield of the ten year treasury. The bipolar Mr. Market was sensing that the dove at the Fed was behind the curve.

After seven months of inflationary and speculative excess in the financial markets, the overheating burst into the lagging core inflation numbers with a vengeance. Even the Fed was startled at how fast it hit. The targets had been exceeded. The speculators, intoxicated on a witches brew of leverage and liquidity, wipsawed the markets with pricing power plus.

Then, like a frat party breaking up as the parental units arrive home to the mess, they reverse field and begin mopping up all the sucker money on the table.

Yeah, the Fed is overdoing it again.

[anne]

I understand, there are problems, and metaphors are finely dramatic and suitably scary. Nonetheless, a conservative value focused diverse portfolio is called for and will take investors through what may or may not be a difficult period following a remarkably broad and deep international bull market. Long term bonds are holding nicely, and I care little about the dollar for we have had years to protect against a loss in relative value should there be a further loss some time or sooner. We have had protective monetary policy for more than 25 years, and I imagine we will continue to be protected.

[anne]

http://www.calvorn.com/gallery/photo.php?photo=4221&u=11085%7C99%7C...

Sharp-shinned Hawk
New York City--Central Park, The Ramble.

Hawks will do :)

[Robert]

I hadn't put the intoxicants and the ridgeline analogies together, but I can see how that image might apply. More soberly, I would characterize "our hiker" on the ridgeline, low on supplies. exhausted, reaching (or surpassed) his physical limits (and it is a "he" since "she" would have had greater foresight in order to precisely avoid this position), as reverting to "faith" to provide deliverance. While I do not under-estimate the immense power of positive thought and visualization, this is never a good sign when there are lots of very large moving parts concerned, such as the global macroeconomy. I think this is fitting because those that discount or dismiss our predicament are predicating redemption upon things like "it may never happen", or "people have been worrying about this for as long as I can remember", "good will triumph over the forces of darkness", or "I have faith in the powers that be" (be they the Treasury, or the Fed), "think positively, don't worry".

As a climber, I will NEVER ascend un-prepared, (mostly because I learn from my mistakes which fortunately wasn't fatal). Faith and confidence might overcome bad luck, but I would argue people confuse this with "will" and "determination" where they've been extricated from the jaws of death. For the past 5 years, US policy has been dramatoically cavalier to the financial risks, exposure of our economy. And while I am not dogmatic that this must end in tears, I do think we have to take charge of the situation, and sort it out (raise revenues, imlement national healthcare; tax energy, encourage alternatives; get out of Iraq, cut military spending; torpedo 'K" street; deliver electoral reform) even if its painful to confront our shortcomings, and requires adjustments to our prevaiiling comfort zone.

[anne]

http://www.calvorn.com/gallery/photo.php?photo=6602&u=99|4|...

Common Grackle Feeding Fledgling
New York City--Central Park, Nutters Battery.

Yes; but, the bright writing as such is wonderful fun :)

[Dirk]

Sir, you should have been more animated about this, like Larry Kudlow was. These 18 straight Fed rate hikes DESTROYED our economy. Raising ARMs, and higher unemployment raised the specter of millions not making their mortgages and having to liquidate their houses, causing a housing crash that impacted the rest of our financial system.

In a world with 3 billion people living on less than $2.50/day, PANDEMIC excess capacity in labor and factory space, and technology obviating commodities (think wireless fo copper, solar for oil, and high-rises for land), constraining growth via constrictive monetary policy is rediculous. With many hundreds of millions of people added to the global economy, new service offerings created, and a whole new cyberuniverse crying to be monetized, it's just like doubling the number of guys at your poker game- you better get more chips.

Don't EVER let the Fed kill our economy by jacking up rates again! We NEED inflation to justify the huge investments appropriate in additional supply and replacement technology.