Fed Watch: Another Recession Call

Tim Duy with a Fed Watch in anticipation of the upcoming FOMC meeting:

Another Recession Call, by Tim Duy: No, not mine. And not Nouriel Roubini's, whose call for a recession in 2007 is exceedingly well documented. Morgan Stanley' chief Asia economist Andy Xie is also looking for recession, but thinking more toward 2008, according to Bloomberg:

"We're headed for stagflation because the bond market believes the Fed," Xie said in an interview today on the sidelines of the International Monetary Fund annual meeting in Singapore. "Recession will happen when the bond market sees through the Fed and sells off. People will have nowhere to borrow money anymore."

…He says that inflation will persist because of rising prices in Asia, whose growth will fuel the global expansion next year.

"Inflation is not going away at all," said Xie. "It's coming from land prices in Asia, and that's feeding into production costs."

I tend to be cautious with "the bond market" is being fooled argument. Still, the Fed was supposedly done after Katrina, and we see how that story worked out. While Roubini expects that the housing slowdown will bring the US economy to its knees, Xie appears to feel that global growth will cushion the blow temporarily while a complacent Fed ignores global inflationary pressures. The Bloomberg article notes that pundit-land is getting increasingly dreary:

Morgan Stanley's New York-based chief economist, Stephen Roach, said that while he didn't share Xie's view, the "odds of a U.S.-led global recession are rising in the 2007-08 period and cannot be taken lightly." David Rosenberg, chief North America economist at Merrill Lynch & Co., forecasts a 45 percent risk of a U.S. recession next year.

One can't swing a dead cat with hitting a gloomy analyst lately. While few analysts are ready to predict a recession for next year, virtually all are hedging their bets in that direction. Market participants made up their minds long ago on what this meant for monetary policy; expectations of additional rate hikes have dwindled to negligible levels. Fed officials, however, have not embraced the gloominess that currently runs amok, leaving a bias toward additional tightening firmly in place. Fed officials just aren't buying the "end is coming" stories, and are instead still peddling the soft-landing scenario. For instance, Bloomberg also reports on Kansas City Fed President Thomas Hoenig's comments on Friday:

Federal Reserve Bank of Kansas City President Thomas Hoenig said today he expects the U.S. economy to grow near or "slightly below" its sustainable pace through the end of next year, helping to ease consumer-price inflation.

"That would be healthy and that would allow inflation to continue to moderate over the course of the outlook," said Hoenig, who is a non-voting member this year of the interest-rate setting Federal Open Market Committee.

Sounds consistent with San Francisco Fed President Janet Yellen's Sept. 12 speech:

Recent data suggest that the needed slowdown is indeed underway. After hitting a rapid 5½ percent pace in the first quarter, real GDP growth slowed in the second quarter to a rate of just under 3 percent. In looking ahead to the rest of the year, I see factors working both to support economic activity and to restrain it somewhat. Taken together, these lead me to expect that we'll probably see growth that is healthy, but somewhat below the rate that is sustainable in the long run.

Of course, the future is not without risks, including the most cited boogeyman, the housing market. According Yellen:

While it's likely that the slowdown in the housing sector will have only moderating effects on economic activity and will continue to unfold in an orderly way, I should note that we can't ignore the risk that a more unpleasant scenario might develop.

This might be just lip service, as Yellen doesn't appear to be losing much sleep on this subject:

While I doubt that we'll see anything like a "popping of the bubble"—in part because I'm not convinced there is a bubble, at least on a national level—it is a risk we have to watch out for.

What about her home state of California?

So Fed officials look optimistic on the growth forecast. Regarding inflation, the "warnings" reported by the press don't sound quite so worrisome read in context. From her final paragraph:

The bottom line is this. With inflation too high, policy must have a bias toward further firming. However, our past actions have already put a lot of firming in the pipeline. With the lags in policy we haven't yet seen the full effect of our past actions. These will unfold gradually over time. By pausing, we allowed ourselves more time to observe the data and more time to gauge how much, if any, additional firming is needed to pursue our dual mandate.

Likewise, Hoenig is not ready to give the all clear on inflation:

Hoenig said today's government report showing the pace of consumer-price increases fell in August was "good news" though "not as favorable as some would like."

In short, policymaker's are expecting a healthy slowdown will tame the inflation beast and, with clear signs of activity slowing, the Fed doesn't have to keep raising rates until the inflation numbers roll over. But, given that they see a moderate slowing, not a deep dive below trend, the bias toward additional firming will remain in place until the inflation numbers do roll over. Considering the current rates on 10 year Treasuries, the Fed simply is more concerned about the inflation outlook than market participants.

(On inflation, see also the rays of hope David Altig sees in the August median CPI data.)

Are Fed officials just clueless? Don't they see that the end is coming? I think not – I bet Fed officials are not working overtime to spin a negative story out of every number (see William Polley on spinning the retail sales figures and Jim Hamilton's broader look at recent numbers). Instead, they will tend to view the incoming data as largely consistent with their views of how the slowdown would unfold. Yes, activity is slowing, but Fed officials are not ready to make the leap between "slowing" and "recession."

But, understandably, so, so many others want to make that leap. The economy is at an inflection point, which raises the risk that an unforeseen shock will pull it from it moorings. Moreover, the Fed's record of actually managing a soft landing is dubious, with the episode in the mid-90's being the only real success story. But a significant disconnect between the seemingly complacent Fed and the gloomy analysts is the potential impact of the housing market reversal. Fed officials are genuinely not overly concerned with the housing-induced recession risk. It could be that they simply do not want to incite panic, but I don't think so. As Mark Thoma reminds us, Fed staff keep pumping out "it is all about fundamentals" research. And there is the view that the slowdown in residential construction will be offset by increase nonresidential construction (Calculated Risk reports on St. Louis President William Poole's thoughts on this). Moreover, I doubt they believe Roubini's story on the importance of the housing for job growth.

Note also that Greg Ip takes up the "Fed-market" disconnect theme in today's Wall Street Journal, noting also that policymakers remain concerned about inflation, may see a lower level of potential growth than generally believed, and, again, are less concerned about housing. I concur – without evidence of a more significant downturn in activity, the Fed will dismiss the building recession fears and hold policy firm, steady rates coupled with an inflationary bias. If you forced the Fed to choose between cutting rates and hiking rates, they would choose the latter. Luckily, they can choose to pause as well.

Comments

[anne]

For them what likes losing money, lots of money, pay close real close attention to the nuttiness that comes out of the daily public ramblings from Morgan Stanley. Listen however to a private client briefing by these same folks, and is there ever a difference. Knowing that, I look for nuttiness that is at least funny and look for ideas on making money much beyond Morgan Stanley, not that they do not make money themselves.

[calmo]

So no surprise that the Fed expects a healthy slowdown rather than the other sort, the precipitous tanking, the bottomless dive into utter chaos...but next Wednesday does Tim expect a continuation of the pause with an outside chance of a resumption in the hikes?
I'm casting my vote with Roubini with an outside chance to anyone with an earlier date for that recession.
Yes, activity is slowing, but Fed officials are not ready to make the leap between "slowing" and "recession." Given that leaping is out of the question for most of the legs on the FOMC, would you say that using the "r" word is a tad incediary for this august body?

[anne]

Suppose, by the way, that I tell you there is a 45% chance of a recession suddenly appearing, woosh, in March 2007. What then, and why not 35% or 55%, and what then? What am I supposed to do along the way, and what then? Growing up, I enjoyed watching Louis Rukeyser, strange kid that I was, and at least Louis always made guests, some of them quite disreputable as it turned out, speak to investment strategy which often would strike me as sound, but what did I know. What are analysts from Morgan Stanley and the other investment houses really telling us, since we don't have Louis to ask?

[anne]

When Nouriel Roubini adds a hint of practicality to the worries he present, I will pay more attention. Calling for the sky to fall, with no suggestion of an umbrella, is simply annoying even though I know how to stay dry as well.

[calmo]

I enjoy the anti-Roach barbs Anne and appreciate the observation that MS investment house has had its moments recently. Yes, hard to know how the pessimistic Roach fits in with the other economists and successful traders in that investment house.
Investment strategy is based on these wisemen's more academic prognostications. I would be floored if Roach came out with a recommendation for a particular Vanguard bond issue instead of those warnings of a chronically precarious global imbalance. [I can tell you I'd being paying tons more attention to your vanguard pages if he did.]
Roach is addressing the public with the intention of influencing public policy decision makers rather than giving portfolio advice IMO. There are more dismal economists out there than SR (Noland at PB for instance)

[Holly W.]

Calmo! Where have you been? I just asked about you last week, and voila, you reappear ...

[nedlink]

I rather suspect that as in many things, the longer a recession is postponed, the worse it will be when it comes.

[Emmanuel]

Trying to read signals from the bond market is difficult given the severe distortions introduced by various central bank interventions in keeping Treasury yields low.

Xie argues that these yields are artificially low due to people being fooled by the Fed that inflation is low, and that a sell-off is eminent once they no longer ignore the man behind the curtain (big, bad inflation).

But, CBs bent on intervention don't give a [deleted expletive not suited for family-oriented economics blogs] about US inflation. Otherwise, they would have sold off some time ago. No, the impetus for a sell-off will come somewhere else, and Roubini provides a compelling picture of where it may arise, like protectionist policies. Different interpretation, same result:

And now, the end is near...

[Richard]

anne: "When Nouriel Roubini adds a hint of practicality to the worries he present, I will pay more attention. Calling for the sky to fall, with no suggestion of an umbrella, is simply annoying even though I know how to stay dry as well."

Ah, but anne, he does make suggestions: cash, TIPS, foreign bonds. He's offering neither the madness of goldbugs nor the madcap enthusiasm of optimists, but the advice that one would offer were they convinced of a recession close at hand.

[anne]

Richard, thank you. I had not noticed a recommendation of Treasury inflation-protected bonds, but that makes perfect sense, though I would always buy them in the Vanguard fund. Nice. Cash however never makes sense, and international bonds have several problems for individuals. International bonds are expensive to buy and sell. Along with normal interest rate risk there is exchange rate risk, as long as I am taking an exchange rate risk for what I wish as a secure investment I will always take it in a value stock.

[dryfly]

For them what likes losing money, lots of money, pay close real close attention to the nuttiness that comes out of the daily public ramblings from Morgan Stanley. Listen however to a private client briefing by these same folks, and is there ever a difference.

Oh to be the fly on the wall, sigh.

I'd guess anne is right - I can't imagine too many MS sales reps out there telling clients... "Sell, sell, now while you still can. Put it all in the mattress... do it NOW!"

Rather it's more like... "Oh Stephen's just being Stephen... pay no attention to him... and besides recessions are for the 'little people'."

Maybe I should consider selling securities instead of American made mechanical parts.

[Movie Guy]

anne,

I have asked you a question on this thread:

September 16, 2006

Why the Difference?

http://economistsview.typepad.com/economistsview/2006/09/why_the_differe.html#c22553169

[anne]

That Nouriel Roubini is offering at least a single reasonable alternative investment pleases me, for I can far more easily take gloom along with suggested ways to be protective.

[anne]

No; the problem is Stephen Roach who, to my knowledge, has never yet been right about economic direction but writes and speaks well enough to be clever seeming and charming though however many absurd projections. Morgan Stanley can be a nice investment, but I would not think of investing with them. Oh dear.

[nedlink]

Anne:

You push Vanguard funds so often I have to wonder if you have some special relationship to Vanguard. If not, a clarification would be welcome to me, at least.

[anne]

No one, beyond an employee, has a special relation to Vanguard, which is much of the reason I and others find the company so attractive. There are 2 companies that are simply different than all else, Vanguard and TIAA-CREF which are the only mutual fund companies that are owned by investors and opperate accordingly. Try to find an investor friendly financial company in Europe or Japan, and wonder why. But, there is always Morgan Stanley for those who wish.

[dryfly]

anne - Morgan Stanley is owned by 'investors'... investors who don't necessarily own MS products.

;)

[anne]

Look to 1980, and you will find that insurance companies dominated household investing. Then, look to the costs of insurance company investing vehicles. Mutual fund companies, costly though at lower cost than insurance companies simply took over the household business. Banks should have easily been able to compete with mutual fund companies, but they never understood that lower costs gave better returns and better returns would be too attractive to ignore for investors. Similarly, why were the mutual funds offered by the brokerage houses a mere afterthought? Cost, and resulting mediocre returns.

[anne]

"Morgan Stanley is owned by 'investors' ... investors who don't necessarily own MS products."

Cleverly so. Remember also that Morgan Stanley offers all sorts of products and services, as does Citigroup. Again, if I am critical of American investment houses I am more critical of the houses operating in Europe and Japan. The absence of meaningful financial market competition internationally is startling, at least to me.

[anne]

We have given almost no attention in this country to what happened in Britain after the public pension system was "privatized." Essentially through a sustained bull market period, investor on investor gained scant benefits from the accounts. Paul Krugman wrote about this. The problem was a remarkable absense of competition that would prove investor friendly in British financial services.

http://www.nytimes.com/2005/01/14/opinion/14krugman.html?ex=1263445200&en=82dced175d45c584&ei=5090&partner=rssuserland

January 14, 2005

The British Evasion
By PAUL KRUGMAN

[anne]

http://www.prospect.org/web/printfriendly-view.ww?id=8997

January 11, 2005

A Bloody Mess
By Norma Cohen

How has Britain's privatization scheme worked out? Well, today, they're looking enviably upon Social Security.

A conservative government sweeps to power for a second term. It views its victory as a mandate to slash the role of the state. In its first term, this policy objective was met by cutting taxes for the wealthy. Its top priority for its second term is tackling what it views as an enduring vestige of socialism: its system of social insurance for the elderly. Declaring the current program unaffordable in 50 years' time, the administration proposes the privatization of a portion of old-age benefits. In exchange for giving up some future benefits, workers would get a tax rebate to put into an investment account to save for their own retirement....

[anne]

Look especially to what incestment costs have done to the Chilean privatization of pension, or should I say do not look for the cost structure is all but impossible to understand. But, Chilean investment returns to pensions have been startlingly low. So, I am interested in this matter internationally and complain at a suggestion.

http://www.nytimes.com/2005/01/27/business/worldbusiness/27pension.html?ex=1264568400&en=c1f60bb2633eed23&ei=5090&partner=rssuserland

January 27, 2005

Chile's Retirees Find Shortfall in Private Plan
By LARRY ROHTER

SANTIAGO, Chile - Nearly 25 years ago, Chile embarked on a sweeping experiment that has since been emulated, in one way or another, in a score of other countries. Rather than finance pensions through a system to which workers, employers and the government all contributed, millions of people began to pay 10 percent of their salaries to private investment accounts that they controlled....

[Mark Thoma]

yes - "incestment" costs are well worth watching.

[anne]

Were I brave enough in battling computers, I would try your magic spell checking Internet guide, but I am not so brave. "My eyes grow weary of the sun." But, there is no sun and I have no excuse though the error really has Freudianism all over.

[J. Gielgud]

Anne :
For them that likes losing money, lots of money, pay close real close attention to the nuttiness that comes out of the daily public ramblings from Morgan Stanley.

Morgan Stanley has a talking a head just for you, for that is good business!! No matter your view be it bullish or bearish, you can find a sympathetic prognostication, from Berners, Lee, Roach, Xie, Jens, Feldman, or the occasional guest piece by Wien or Biggs. Who needs consistency? Just give 'em validation in exchange for some trust. And as you point out, there is another whole side dedicated to private clients, or high net-worth folk who can mix-'n-match the research to the customers whims. Recall that Morgan Stanley was one of the firms along with Goldman Sachs who inadvertantly waylaid their e-mail records and so sadly could not provide them to the Justice Department for their investigation into conflicted or outright bogus research. But that was then, and this is now, and I am sure it's all cleaned up now, and honest. Oh yes surely. Now, about those e-mails....

[calmo]

So, was Tim saying Wednesday is a pause and that the recession has been postponed indefinitely due to perturbations beyond his control? [Do people care or are they distracted by Setser's worries over funding the CAD this past quarter?]
"Incestment" was a wonderful slip (who am I to judge the Freudian aspect?) that really does capture the recent windfalls of the banks and investment houses in particular. Thank you for reminding us of the recent UK and Chilean experience Anne.

[Movie Guy]

anne,

Appreciate the response on the "Why the Difference?" thread.

MG

[Movie Guy]

Where is the mention of declining retail fuel prices?

[ljm]

Looking at the pictures of the violence in Hungary brought on by being lied to about the economy there. This isn't going to blow over and I have to wonder why people here aren't just as furious about the lies we've been told about our economy?

[Richard]

anne: "Look to 1980, and you will find that insurance companies dominated household investing. Then, look to the costs of insurance company investing vehicles. . . . Similarly, why were the mutual funds offered by the brokerage houses a mere afterthought? Cost, and resulting mediocre returns."

Anne, I broadly agree with you on Vanguard and TIAA-CREF. Both have very low annual fees and have built funds on broadly based, cap-weighted indexes with extremely low trading costs. This contrasts sharply with the vast bulk of for-profit financial services companies - from the pensions administered through insurance companies to the mutual funds offered through brokerages. When fees are above 1% you know you are being ripped off; when fees exceed 0.5% you can likely get a better deal elsewhere.

That being said, it's worth noting that Merrill Lynch - yes, that Merrill Lynch - was at one time considered a radical innovator, cutting Wall Street fees and bringing investment to Main Street. I'm haunted by the notion that Vanguard, perhaps through complacancy and the changing of the old guard, could have the same thing happen to it a few decades hence. Why does a company which has broadly made its reputation on index funds and low-cost investments need actively managed funds? Similarly, why the need for sector-specific funds in the U.S. market when funds for real additional diversification (foreign property and foreign value would both seem to be useful) are lacking? It is not uncommon for today's bold innovator and cost-cutter to become tomorrow's bloated laggard.

I have largely invested in Vanguard's funds and ETFs. But I am also pleased that there is some realistic competition - from DFA, from ETFs and from fundamental indexes. I'm not sure I subscribe to the rationale of some of the new products, but the fact that the marketplace of ideas is actually producing real products with ever more reasonable fees is appealing.

[anne]

Interesting comments to think through.

[Cyrille]

I don't see why Roubini should need to give an investment recommendation in order to be credible. Not EVERYONE has to be an investment consultant, nor is investing the main concern of everyone. One can surely be an economics analyst without pretending to be an investment wizard.

[calmo]

ljm raises a good question about our acquiescience. I am reminded of the relatively dramatic (and healthy) response of (il)legal immigrants and suspect that their lack of exposure to media was the main condition for this demonstration. Is our capacity to demonstrate disapproval controlled/conditioned by our exposure to media?
Cyrille, anne needs the escape route, the protection, the safeguards, the reassurances. Roubini has tenure.

[anne]

Yes and no; an economist does not need to be an investment analyst and investment analysts can be awfully tricky to deal with, but economists who comment continually about our health or lack of health have an implicit obligation to know enough of the basics to suggest ways of self-protection. Nouriel Roubini blithely calls for a bear market in stocks, even including a false bounce, a fierce bear market, which supposes knowing something about investing values, and beyond mentioning cash in the complete essay I read there was no mention of what might be done. Cash is mere foolishness as advice, and the rest is not legitimate if the economist knows to little to suggest sensible recourses. Phooey.

[anne]

There are implicit obligations that come with public discourse in all specialties. Louis Rukeyser, though problematic in several ways, at least knew of such obligations and was an institution as a result.

Calmo, by the way, is always interesting.

[reason]

Anne,
if there really would be a slump soon then cash is not bad advice. I sometimes think, if we let everything really go crash (which won't happen), then people like me who are relatively cash rich will be laughing. After all given the price of Chinese and Indian labour, I could buy an awful lot of services with my savings. I just can't convince my family to move to India more's the pity.

Unfortunately, it is more likely that we will inflate our way out of trouble in order to save those with debts. In which case the cash the soon be gone. Still I want to wait to after the recession, to see which firms are still left standing before I invest fully.

[reason]

By the way Anne, I don't live in the US and I don't trust the US dollar so your TIPS don't appeal to me.

[Robert]

I disagree with you Anne, ye of little tolerance for things un-panglossian. There is no implicit requirement - real or imagined - for an economic forecaster to also be a tactical strategist. I do not ask my architect what is the best surface treatment to use on my walls underneath the paint. My painter knows better than anyone what preparation & primer best suits the stone, desired texture, and chosen paint.

Unlike most "big picture" investment strategists who it seems lick their finger and stick it up in the air to forecast macro unfolding of events, Dr Roubini at least provides more solid and well-researched foundations upon which his forecasts are built (irrespective of whether you agree with them or not). And even the most optimistic and determined of asset allocators will admit that there are certain investment periods (the most recent being 1976-1980) where strictly speaking virtually all asset classes provided dismal returns, and where no investment i.e. cash, (or for those who could, outright "disinvestment") was the optimal course to follow.

[anne]

There are government inflation-protected bonds in the prime European currencies. Europe had such bonds well before we did, and there is no currency risk in a French or German long term resident or citizen buying inflation-protected bonds in Euros.

The point about cash, however, is why not hold bonds of a given duration that pay more in interest than cash and generally ignore near term changes in economic conditions knowing that over time the additional interest will always be more than might be made holding cash. Besides, timing markets is really really really hard intellectually and emotionally. Going in and out of cash is a way to be relatively poorer.

[anne]

The architect analogy pleases me, for I enjoy architecture, but an architect had better know surfaces and finish or be consulting with finishers in designing a structure. But, I may be too critical simply because the pessimism is annoying even if possibly warranted.

[Robert]

Sadly, as with investment strategiests, there are many architects that should be the AIA equivalent of "disbarred", though in practice most are allowed to continue designing "inaccessible windows", impossibly unreachable cupboards, homes that don't "breathe", and volumes of space in climate-controlled dwellings that are when when adorning a spread in Unbelievably Contrived Home magazine, but that are at once impossible to heat and/or cool, not too mention impractical to actually inhabit. But maybe I - like you - am also being too critical...:)

[anne]

No matter, architecture is important and we can be as critical as we wish knowing what it can mean to a locale or neighborhood or householders and how often what it does not mean.

[calmo]

Given that the architect makes the same amount (~6%) for her work as the real estate agent who sells it, there is no doubt who is better trained and who is better remunerated for their services and who makes the larger contribution to their community.
Similarly (ok, maybe not)[Don't let those 'similarlies' push you around people] Roach is a popper compared to the traders in investment houses. And Roach has a social conscience, despite the shellacking he is taking from Anne, that I cannot find in those traders.

[Richard]

Architecture is a nice metaphor. But just remember that architects too can produce inferior works; they too can sell their services to the highest bidder, produce inferior works and move on.

Anne, you suggest inflation-indexed securities that are non-dollar denominated to those who are fearful of a recession. I note that there is not a simple indexed fund of bonds from OECD (or EAFE, if you prefer) countries to be had. Not by Vanguard, or TIAA-CREF, or one of the ETF providers (although there are overpriced funds by PIMCO and others). Yet here is an opportunity to provide an asset for investors who know that cost matters and are interested in a portfolio that is as widely and reasonably diversified as possible. Certainly there is a case to be made for non-US real-return bonds as a portion of a portfolio, just as there is a case to be made for foreign property and foreign value.

[georgist]

Real estate agents are not remunerated for their "contributions to their community". Rather, it's the other way around: they get big money from absentee land speculators, who buy up land and keep it idle, seeking to pocket the "capital gains" that community development creates. This would not be a problem, except that the supply of land is fixed and cannot respond to speculation, so the end result is artificial scarcity, exaggerated price swings and general instability.

[nedlink]

Thanks, Anne, for the clarification. I too approve of Vanguard and esp. its index funds. If you want to see rip-offs of customers, go to Portugal where people know virtually nothing about stocks, and where the banks take advantage of that.

[anne]

Nedlink

We have a bunch of nice Portuguese readers of this blog; I am impressed. As you think of financial comparisons and anecdotes relating to Portugal, please add them. Portuguese and Spanish banks are evidently concentrated in number and powerful both at home and increasingly through Latin America.

[Robert]

Banks across Europe are "clip-joints" from the perspective of investors. This is true whether one desires to deposit funds for savings purposes, make an international transfer, convert funds into another currency, or invest in a collective investment scheme, be it bond or equity based. Though its bad in almost all countries, the worst are the pseudo-thieves in Switzerland, Luxembourg and the Channel Islands. Steep fees and seven ways-to-tuesday to pilfer from your account or use smoke & mirrors to steal it more stealthily. "Bank" and "Fiduciary" cannot be spoken in the same sentence without immense qualification.

[calmo]

nit picker qeoqist is correct (but not absolutely) Real estate agents are not remunerated for their "contributions to their community". provided one views "community" the way the mafia veiws family. So many occasions where referencial opacity is designed to mask rather than accidentally fail to illuminate [This could be an instance]. Yes?