What Should the Fed Do? What Will the Fed Do?

What should the Fed do? I think the Fed should pause at its meeting next week, let past tightening catch up, and reassess the situation at September's meeting. That will reduce the chances of overshooting.

The question "What will the Fed do?" is harder to answer. David Altig at macroblog looks at the chances the Fed will raise rates at its next two FOMC meetings:

All Systems Stop, by David Altig: At midweek, Tim Duy wrote this at Economist's View:

Futures markets appear to have no clear conviction on the outcome of the next FOMC meeting. The message is that market participants are looking for one more rate hike, either in August or September. Moreover, they doubt the Fed’s position that “pause does not mean done.”

That was indeed the case then, but this is now.  ...[H]ere is what the probabilities estimated from options on federal funds futures look like as the week of before the next meeting of the Federal Open Market Committee begins:

Friday's second quarter GDP report really wasn't all that bad, but apparently not as good as expected was enough.  And Professor Duy was right -- the market does seem to doubt the Fed’s position that “pause does not mean done.”

It's still a relatively long time to September, but at this point it is hard to see what might significantly shift sentiment about this week's meeting.

UPDATE:  I take it back. Tomorrow's ISM and PCE reports could loom large.  And there was this, from Federal Reserve Bank of St. Louis president William Poole:

Federal Reserve Bank of St. Louis President William Poole said he's undecided on whether the central bank should raise interest rates at its next meeting in eight days.

Poole, speaking to reporters after a speech in Louisville, Kentucky, said he's "50-50'' on the decision, which needs "all our analytical skills.'' Recent data show slowing economic growth, while inflation has "tilted'' upward, he said. Containing inflation is the Fed's "primary'' goal, he added.

UPDATE II: Action Economics (subscription required) reports:

SF Fed's Yellen did note rule out more rate hikes though she said that the Fed funds rate is "in the vicinity" of the right level, noting the Fed remains responsive to the data and she expects below-trend growth later in 2006 to pull down inflation. Yellen also confirmed that the Fed was mindful of policy lags and even though core inflation is above her comfort zone, the Fed can pause before it begins to decline, while retaining a more restrictive policy setting... Overall the comments are fairly balanced and do not rule in or out another hike in August

Bloomberg also reports, with a somewhat dovish reading of the statements:

Fed's Poole, Yellen Say Economic Outlook May Justify Interest-Rate Pause: Two Federal Reserve officials said the economic outlook may justify a break from two years of consecutive interest-rate increases, signaling policy makers could leave the main U.S. rate unchanged next week.

San Francisco Fed President Janet Yellen said ... "It appears to me that the federal funds rate currently lies in a vicinity that is roughly appropriate for the Fed to attain its key objectives over the medium run,'' ... "If we kept automatically raising rates until we saw inflation start to respond, we most likely would have gone too far.''

Yellen's remarks appeared to outline the case for a pause, while emphasizing that data surprises, especially on inflation, could also alter her outlook. Answering reporters' questions afterward, Yellen said she wasn't revealing how she would lean at the FOMC session.

"I don't think it's the case that I have favored a pause or attempted to indicate what my inclinations would be,'' Yellen told reporters. "I've attempted to give a balanced presentation that would say, essentially, we are at a delicate point for policy. We're, say, close to the end of the road.'' ...

Yellen said inflation rates are "disappointing'' and "somewhat above my comfort zone.'' She added that there are "upside risks'' to her inflation forecast. "The extent and timing of any additional firming should depend on how emerging developments affect the economic outlook,'' ...

As the WSJ notes, and David Altig notes above as well, there are several key reports yet to come before the meeting, and these could affect the economic outlook:

Several reports due out later this week could have a big impact on whether the Fed decides to raise the target for the federal-funds rate by a quarter-point for the 18th time to 5.5%. Tuesday, the Labor Department will release data on personal income and spending, a report that contains closely watched inflation metrics. Also Tuesday, the Institute for Supply Management will release its July manufacturing index. On Friday, the government will issue the nonfarm payroll report for July.

Comments

[spencer]

My version of the Taylor rule has flatten out -- it is no longer rising -- but it says that funds should be 6%.

But it has been saying fed funds were too low since 2002.

[hj]

Roubini predicts a recession whatever the FED does. That the FED is no longer in control of the situation.

[dWj]

I don't think the fed is likely to stop any oncoming recession, but I don't think they should try to, even if they can.

More to the point, though, as the economy slows, the interest rate that constitutes "neutral" is likely to drop. 5.25% may not be restrictive yet, but it will be if held another six months. I'm still not sure, though, that this doesn't mean the right policy is to raise rates now, with the full knowledge that cuts will be coming soon. There's no reason the fed should try to round off edges in interest rates, as opposed to (for example) rounding off the degree of financial tightening that it implies (insofar as that can be ascertained).

[short1918]

I recently wrote a pretty botched up paper on what I thought the FED would do on Aug. 8, so here is my chance to redeem myself. I think that Fed will increase interest rates with a quarter of a point and after that I think they will have achieved their goal of helping to lower/maintain inflation. The prime rate is 8% as it is which is a pretty good chunk, if you consider that people applying for variable rate loans who have fair to good credit are going to be paying out the ya-ha for it!! I disagree with the statement of pausing for Aug. and increasing in Sept. b/c I think that to be on the safe side they better try and tackle inflation now, b/c who knows what could happen at the end of this quarter, especially with Lebanon and Israel and Iraq in the "works". For all they know crude oil could soar to even higher levels than previously projected and in this situation, at least I think, its better to be a quarter of a point safer than sorry.