Tim Duy reviews the decision by the Fed to hold rates constant:
The Long Fabled Pause, by Tim Duy:
A pause at last,
a pause at last,
a pause that depends
on the forecast.
Will the Fed remain steadfast,
if the months ahead bring,
inflation news that is chilling?
- Anonymous, though almost certainly not an English major.
I knew, or at least strongly suspected, that, in the wake of the July employment report, I was going to be on the wrong side of this Fed meeting. I absolutely hate being on the wrong side of these things. Worse yet, I feel like I have been on the wrong side of the last two meetings.
As it turns out, the slowdown story I was peddling back in June was the correct story, with the shift to inflation paranoia being a temporary diversion that I clung to a bit too long. Fed policy has long been predicated on a belief that the steady series of interest rate hikes would work its way through the economy via the housing/consumer channel. With plenty of evidence mounting that slowdown is less of a forecast and more of a reality, as the FOMC statement implies, the Fed is now set to shift into watch and see mode.
The diversion into inflation paranoia was an attempt to reset expectations, presumably to prevent market participants from believing that a pause meant done. At this point, that issue appears irrelevant; markets are pricing in only a small chance of another rate hike, and the talk is turning to the timing of the first rate cut in the next cycle. The question is not if the economy will slow or not; that has long since been answered. The question is how much slowing will occur.
The Fed’s view, I believe, remains the same as the forecast that accompanied Fed Chairman Ben Bernanke’s testimony last month. Growth is expected to slow to somewhere around potential, thereby easing inflationary pressures. An outright recession is not expected, as investment spending and improving exports provide a cushion for the economy. I should note that I doubt the Fed believes the widely touted claim that “investment spending will fill the gap left by the consumer.” This terminology suggests that economic growth will not slow. The conventional wisdom, which I believe holds sway at the Fed, is simply that a recession is not typically a consumption driven event; it is an investment driven event. The Fed’s forecast will likely incorporate a slowing in investment spending, but not a recession inducing reversal. Likewise, I believe they would tend to discount the investment swing in the GDP report as reflecting swings in the data (the 4Q05 slump offset by the 1Q06 surge followed by the 2Q06 reversal). I have argued they would be more accepting of the investment collapse story if the higher frequency data (industrial production, durable goods, ISM, and Beige Book) was more supportive. That is likely still the case; if not, then this meeting shouldn’t have been much of a nail biter.
And apparently it was something of a nail biter, with the dissent of Richmond Fed President Jeffery Lacker indicating that the pause was not a sure thing going into the meeting. Beyond that this was not an open and shut case, however, I wouldn’t make too much of the dissent. While it is likely he had some sympathizers in the FOMC, none were sympathetic enough to support his dissent. Moreover, Lacker’s dissent is something a political no-brainer. If he is wrong, no harm done, as the FOMC chose to pause, and the dissent will be forgotten to all expect Fed watchers, and maybe Bernanke. If he is right, and inflation does spiral out of control, then he can be the “I told you so” guy.”
Which then brings us to the issue of inflation. The Fed is staking out a position that may require significant resolve. The bet is that the economy will slow enough to allow the Fed to wave off the current set of hostile inflation numbers as reflecting the temporary impact of past growth and energy price spikes. They are making this bet when inflation signals are climbing – the spike in unit labor cost in 2Q06 likely helped prompt the removal of the “productivity optimism” clause from the FOMC statement – believing, not without basis, that inflation (and its compatriots) is a lagging indicator that will keep rising for maybe four quarters after the economy has rolled over.
If the economy plunges into recession a lá Nouriel Roubini, then the Fed’s position will not likely require much resolve whatsoever. A more challenging scenario is the Fed’s forecast – stable though slower growth with inflation clinging north of 2%. Sitting tight while the lagged impact of past growth works through the inflation numbers would likely test the patience of some FOMC members, such as Lacker. Financial conditions look consistent with such an uncomfortable outcome. Even as ten year rates have slipped below 5% with the growing focus on slow growth, the spread between inflation indexed and nonindexed 10y Treasuries is holding closer to the upper end of its “well contained” range:
My tendency is to favor the Fed’s forecast that slower growth will ease inflationary pressures as a respectable baseline scenario (with the admission that still unstable energy prices complicate this outlook). If you are pessimistic on inflation, believing that the real lagged impacts we are still waiting to see are such things as commodity prices, housing prices, etc., then this is the time to bet against the Fed. And you can take heart in the Bank of England’s 25bp hike; not just a few view the BoE as a good leading indicator of where the Fed is headed.