Fed Watch: Widening Disconnect

Tim Duy explains the growing disconnect between market expectations and Fed communications:

Widening Disconnect, by Tim Duy: The countdown to the next FOMC meeting is underway, and the gap between market expectations and the Fedspeak appears to be widening. Quite honestly, I find such periods very, very uncomfortable, mostly because I feel Fed watching amounts to explaining a position taken by the Federal Reserve that the markets believe is increasingly untenable.

For example, note Monday’s speech by Dallas Federal Reserve President Richard Fisher:

As I sit at the FOMC table, I continue to fret more about inflation than I do about growth. While I am well aware of the risks to economic growth, the history of inverted yield curves, and the ever present possibility of exogenous shocks in a politically hazardous world, the “balance of risk,” in my book, is still tilted to the inflation side of the equation.

I have said in the past that perhaps the best strategy is to bet against Fisher, and market participants appear to be taking that advice to heart, as the yield curve shifted down yet again despite these hawkish words. Of course, Fisher does make the required reference to the housing slowdown, but focuses on the upside potential for the economy while reciting anecdotal evidence of tightening labor markets:

One of the most experienced CEOs I regularly visit summarizes it this way: “We were all expecting things to be worse, but they haven’t gotten worse. We were all expecting things to get tougher, but they haven’t gotten tougher.”

Except in one area: procurement of labor. I am hearing more and more reports about the difficulty of finding labor to work our oil fields or run our chemical plants. Bankers complain of a paucity of bank clerks and tellers. Truckers are experiencing a shortage of drivers. In Houston, we are hearing complaints about the difficulty of finding cashiers for retail establishments. A major hotelier told me last week that there is a shortage of housekeeping staff. And for those who source abroad, finding ever cheaper inputs has become noticeably more difficult as growth in sourcing countries eats up available capacity. Having achieved a considerable amount of operating leverage from outsourcing and aggressively pushing the envelope of cyberspace, companies are now voicing the kinds of complaints about labor shortages most often heard in a full employment economy.

Of course, a trained macroeconomist would at least note that employment is a lagging indicator. Oddly, he doesn’t seem to understand this, since he then continues on to list a litany of surveys indicating slower growth ahead, which he then discounts to conclude that growth is simply slowing back to potential. In reality, it is all very frustrating, especially considering that Fisher appears to view the Fed watching community with certain derision:

After participating in those discussions, it is always instructive to sit back and read the various interpretations that pour forth from well-meaning analysts about what action the committee took or did not take and what was said or left unsaid in the press release that follows the meeting. I liken this process to the ancient ritual of divining the future by slicing open animals to study their entrails. The analytical community dissects our statements and presumed intentions with the greatest of care. It is definitely less gory than the rituals of ancient civilizations. But it is only slightly more accurate as a predictor of the future.

I really shouldn’t take the bait, but I have to point out that we might not have to read the “entrails” if the Fed actually developed a consistent communication strategy. All right, perhaps that is simply too much to expect. Instead, how about simply a single inflation target? In Fisher’s speech, he draws attention to the CPI, the Cleveland Fed’s median CPI, and the Dallas Fed’s trimmed mean CPI. Which one, exactly, should we pay most attention too? But wait, isn’t the Fed’s preferred inflation measure the core-PCE, which Fisher fails to mention? And if core-PCE is not the relevant variable for policy, why is that the one singled out in the Fed’s Semiannual Report to Congress?

But I digress. While Fisher is rattling on about the Fed’s inflation bias, the market is busy driving the 10 year Treasury below 4.6%, while, as astutely noted by Calculated Risk, busy little traders are beginning to price in a rate cut for December. This, I believe represents a significant disconnect with the thinking at the Fed; in the Fed’s view, the data represent a welcome slowdown, not cause for a rate hike. Moreover, Richmond Fed President Jeffrey Lacker was still pushing for a rate hike last week. Simply put, I can’t see where monetary policy makers are looking toward a rate cut. If forced to choose between hike and cut, I still suspect they would actually choose to hike.

How then could the markets be getting so far in front of the Fed? While it is dangerous to assume too much about the motivation for market behavior, note that the expectations for a rate cut began rising after the last FOMC statement, where the Fed reiterated its inflation bias. Market participants appeared to ignore this, however, and instead shifted attention to the Fed’s focus on the contractionary impact of the housing slowdown. Last week, I criticized the Fed for not expanding on that point, commenting:

If housing is your focus, cut rates now! They didn’t cut rates, so there must be more. So where is the rest of their analysis? What are the factors that offset the housing slowdown? Inquiring minds want to know.

So, regardless of whether or not the Fed intended to intensify the focus on housing, that is what happened. And if you focus on housing, it is tough to see anything in the future other than a rate cut, especially with the first national price decline in years threatening to help derail the steady flow of home equity withdrawal that has helped propped up the economy.

Bottom Line: The Fed is looking at more than housing; especially important is this week’s advance durable goods and personal income reports, the latter containing the important PCE inflation reading. This broader look at the data is what the Fed uses to justify its inflation bias. But the Fed has also intensified the market’s preoccupation with housing – and since there is no good news in housing, the disconnect between Fedspeak and the markets is not likely to resolve itself anytime soon.

Update: In light of Tim's comments, note these two back-to-back entries on Bloomberg Breaking News:

• Volcker, Corrigan Warn of Inflation 'Creeping' Higher, Threatening Growth
• Federal Reserve to Cut Interest Rates in 2007, Corporate Bond Sales Show

Comments

[calmo]

Tim bites back:I really shouldn’t take the bait, but I have to point out that we might not have to read the “entrails” if the Fed actually developed a consistent communication strategy. Fisher might as well be referring to his own ramblings which could stand a little housekeeping, IMO.
The banking business is too boring for this gentleman. He needs room, (R-O-O-M people) to put in a crowd-pleasing performance. Yes, Fisher is spending too much time with the performance and we are distracted by his self-facination. He's intruding on our role and we need to take the fly swatter to him to get him to back-off.
I'd say Fisher is more disconnected from the Fed than the market is from the Fed. Again, Bernanke is allowing more freedom of expression (Fisher clowning for instance) than Greenspan did.

[Rajesh Raut]

I enojy reading Tim Duy's commentaries on the Federal Reserve but I must disagree with him. I think the Federal Reserve is closer in its assessment of the economy than the stock and bond market. The bond market seems to be pricing in a end to the universe. While the housing slowdown is sharper than we have experienced in many years, it is not yet enough of a shock to tip the economy into recession.

The long, slow campaign to remove the monetary accomodation was exactly to slow the madness of option ARMs and no documentation financing. Sales are down but from a very high level. While it will be small comfort to the people involved in home building, real estate and mortgage banking, the rest of the economy is holding up and the resources released by the housing sector should restrain inflation in the overall economy.

Prices of housing normalizing is a bad thing for the owners in overheated markets, but the benefits to the rest of us are substantial.

[rana]

Let's see. the Fed has one instrument and two targets one heading south and the other north. Some bank Presidents (Fisher, Lasker, Moskow) seem to be focused on infaltion while others (Yellen, Geithner) seem to me more worried about the real economy. The market is currently voting with Yellen. But, given current expectations for real GDP over the second half of the year, its hard to to see a rate cut this fall.

[Winslow R]

.." the rest of the economy is holding up" ...

The latest numbers (from last week) show all sectors faltering towards recessionary levels for the first time since the 'switch' was thrown in August. We'll see if this week's numbers confirm the trend.

[anne]

http://flagship2.vanguard.com/VGApp/hnw/FundsByName

Vanguard Fund Returns
12/31/05 to 9/25/06

S&P Index is 7.6
Large Cap Growth Index is 2.1
Large Cap Value Index is 12.5

Mid Cap Index is 5.1

Small Cap Index is 6.5
Small Cap Value Index is 10.0

Europe Index is 19.1
Pacific Index is 2.0
Emerging Markets Index is 8.7

Energy is 3.6
Health Care is 9.3
Precious Metals is 15.3
REIT Index is 23.4

Long Term Bond Index is 2.1
Intermediate Term Bond Index is 3.0

[anne]

Though the international bull market in stocks continues, institutional investors appear to be increasingly cautious. Long term Treasury bonds carry a remarkable 4.55% yield, which makes this the most sustained and pronounced inverted yield curve period I can find record of. Yes; I am cautious and worried.

[anne]

The questions in coming months will continue to be just how broad and deep the housing market slowing will be, and the problem is that we have not before experienced a housing boom as we has just passed through. Were I Ben Bernanke, I would be ready to push hard for a lowering of short term rates if the housing slowing continues much longer.

[quiz]

Volker had to draw a line in the sand to wring the speculation and expectations out of an overheated economy. The previous irresponsibility of the Fed does not mean that it has to continue. Inflation, and worse, inflationary expectations have not subsided.

The Fed Funds rate is not restrictive at 5.25 %. The stress we are feeling in the housing market continues to be trumped by the speculative bubblemaking steamroller on wall street.

A reduction in rates at this point would be pre-mature. The future path of the current unbalanced economy is inflationary if it is monetized. It is not a question of supply constraints. The retrenchment in oil prices in a few short weeks and the hedge fund meltdown indicate to me the degree of speculation dominating the markets. Stimulation is still coming from the Republican government, foreign mercantilists, and plain old speculation.

Why would the Fed cut rates ?. Long term rates are already pretty low and, historically, 5.25 % is low.

[anne]

What gives me a fair measure of confidence is the robust commercial real estate market nationally, and the low long term interest rates may give a general limit to further declines in home prices at least in population expanding urban markets. Notice, what I am told by professionals means little but I have found useful, the robust Vanguard real estate investment trust index.

[calmo]

Good post (lots I like here) quiz but in answer to 'Why would the Fed cut rates?' I'd say to prevent the housing market from imploding. [And you could say that I was disconnected from the UK experience where nothing of the sort has happened, so why the fear of implosion here?]

But I need to say something about the language here. Specifically, the wide-spread use of the word 'disconnect' both in describing the market's response to the Fed and the Fed's response to decade low numbers in housing.
It reminds me too of the slogan "being left behind" (those children, those people who are not connected to the internet, those non-subsribers to NRO,...)[I jest people] (I dare not take any risks on folks who may have just plugged in.). It is the flip side of 'reaching a consensus': don't think different or you'll be left behind. Connect now or sink outa sight...(the sound of a toilet flushing)
The flamboyant Fisher (his brother was a prima donna in the Australian national opera company) does annoy me, no bloody question. But I want to ignore him for the moment.
Entirely.
The Disconnected Logic (from one who knows people, I am so connected):
'Are you connecting with me?' has so many over-tones, but I think the melody line is: Do you understand me, you knucklehead?
Possibly it is more charitable than that ('Can I make the connection clearer by re-phrasing my point?'), but generally if there is a disconnect, there is a disconnected party...and they are bozos (not you, not the party they are disconnected from).
If you are not disconnected, we rarely point this out ("I see you're connected today: trousers on with the zipper to the front AND socks on both feet!"). It is the herding trumpet: don't go astray. A few blasts of "... is disconnected" sends out the posse (maybe the lynching mob).
Last thing (I know staying connected to long threads can be punishing): the market, more than ever, represents wealthy interests (I am not that well-connected but I imagine certain segments of the market (the hedge fund indices I would guess) are even more representative. So to say there is a disconnect between the market and housing (as one [semi-connected] commenter at Calculated Risk does) presumes [the semi-disconnection:] that we all have common, more or less equal, more or less personal, interests and stakes in these 2 facets of our economy. And we demand they be connected so we can regain our composure and put our anxieties to rest that we might be Inforit.
Nobody likes being lost. (Wandering is different and wondering is different again.)

[Robert]

The non-sequitir is not between The Fed and Markets, but between The Bond Market and the Equity Market and other hard-Asset non-residential markets. The Fed is inherently conflicted, and a cock-up in either direction could be fatal, and so is doing the best - in fact the only thing - it can under the circumstances which is to keep the yield curve as flat as the market(s) will bear.

The bond market has seen it's manhood placed in a lockbox somewhere beyond the western shores of the Pacific, probably Beijing. Now, when it squawks everyone should eye what it says suspiciously for without its manhood its pronouncements are compromised and dishonest. Return the nearly $2 trillion held by PBoC & BoJ to the equation, and lord knows what the restoration of it's freedom would result in for the bond and fx markets. The equity market is staying this paper will never see the light of day. All the other hard asset markets - commerical real estate, farmland, timberland, infrastructure, commodities are seemingly bracing themselves for a deluge.

I can accept that these $2 trillion or so may remain in their lockbox until Prince Naruhito comes of age, neither fueling inflation, nor raising interest rates. The bond and equity markets in fact are betting on precisely this.

But that still leaves us the CY2007 trillion dollar question: With no end in sight to the USAs fiscal and trade imbalances, Who on earth pray tell will take down the next trillion at current interest rates and FX prices without upsetting the applecart?

[Robert]

p.s. If you answer "the PBoC & BoJ", you should be prepared to answer "why" to get your Kewpie doll...

[calmo]

So, erectile dysfunction in the bond market Robert? [I am savoring your eloquence, I am.] Does appear to be some sagging in those tbill purchases esp from those central banks but I'm counting on Setser's much better equipment to sustain/inform/guide me, you?

[Robert]

Setser's good and will give the world a proper heads-up as & when things change. But watching TIC data seems sort of "hand-to-mouth", and that will, in any event be too late. Personally, I would like to believe that both US policy-makers (including the Fed) have "a plan" that does more than rely upon the monthly magnaminity of strangers - especially when such strangers are self-serving neo-mercantilist ones whose long-term interests are unlikely to be aligned with yours, mine and ours...

[donna]

Bond markets are supposed to be an assured return, not a display of manly fortitude. That's kind of the point of having a bond market.

If you want speculation, it's in the stock market. Tome it's money looking for a place to make more money, and if it's too high, it means there ain't nuthin else to invest in. Hosuing bubble went boom, money is still sloshing around looking for a place to be. If interest rates are kept low, there's no point in saving it, which means banks cna't loan out to real investors. And the economy goes nowhere.

The problem with keeping interest rates artificially low is not that it doesn't fight inflation, it's that there becomes less and less incentive to actually save and invest. It's very, very short-sighted of the fed indeed to keep interest rates too low.

Very.

[knzn]

Reading about Fisher, I am reminded of the story of the 5 blind men and the elephant. This particular blind man has his headquarters in the middle of the nation’s oil-producing region. Is it any surprise that he thinks this strange beast resembles a full-employment economy?

[Tony G]

The central bank game right now is to rhetoric about inflation. It has little to do with policy. In fact, it is a policy in itself. Speak loudly and carry no stick. The inflation rhetoric started at the Fed, moved to the ECB, now is at the Bank of England. Fisher is playing a game that ended two innings ago.

[anne]

http://flagship2.vanguard.com/VGApp/hnw/FundsByName

Vanguard Fund Returns
12/31/05 to 9/25/06

S&P Index is 7.6
Large Cap Growth Index is 2.1
Large Cap Value Index is 12.5

Mid Cap Index is 5.1

Small Cap Index is 6.5
Small Cap Value Index is 10.0

Europe Index is 19.1
Pacific Index is 2.0
Emerging Markets Index is 8.7

Energy is 3.6
Health Care is 9.3
Precious Metals is 15.3
REIT Index is 23.4

Long Term Bond Index is 2.1
Intermediate Term Bond Index is 3.0

[anne]

There has been a broad and deep international bull market in stocks since October 2002, while internationally value stocks have been in a bull market for a decade. Similarly, while bonds are relatively weak this year, Vanguard long term bond index has returned a fine 8.2% over the last decade and coming from a bull market in bonds beginning in 1981-1982.

Forgive me if I am missing something, but there have seemingly been fair investment values in stocks and bonds through this difficult decade, and through this 6 year period of especially low interest rates. Vanguard inflation-protected securities fund has returned 8.2% a year since beginning in June 2000.

[anne]

Darn; I meant to post investment returns for the decade and not for the year which I had already posted.

http://www.mscibarra.com/products/indices/us/performance.jsp
http://flagship2.vanguard.com/VGApp/hnw/FundsByName

Vanguard MS Fund Returns
8/31/96 to 8/31/06

Large Cap Index is 9.0
Large Cap Growth Index is 6.4
Large Cap Value Index is 11.3

Mid Cap Index is 12.3
Mid Cap Value Index is 15.1

Small Cap Index is 11.9
Small Cap Value Index is 14.2

Europe Index is 10.8
Europe Value Index is 13.7
Pacific Index is 2.4
Pacific Value Index is 4.4
Emerging Markets Index is 7.9

Energy is 17.9
Health Care is 17.3
Precious Metals is 12.1
REIT Index is 15.3

Long Term Bond Index is 8.2
Intermediate Term Bond Index is 6.8

[calmo]

Could all of donna's typos be legitimate?
Hosuing bubble is one of the cleverest things my eyes have feasted upon in years.
Ok, it could be accidental.
And donna could be modest.
What of the pithy cna't? or, if some feel I skipped Tome did your mind run through 'Time' before you spaced it out?
Folks, donna doesn't preview --like the rest of us smaller minds...that is my take.
Consider the response to suggestive language in this: Bond markets are supposed to be an assured return, not a display of manly fortitude. That's kind of the point of having a bond market.

If you want speculation...
Shoot, I'm speculatin, no question.

I shall not be distraced.
Not any further.
Last thing (Very last thing) Now that others have posted after donna (ignoring those typos too --not a sign of mere erectile dysfunction IMROBUSTO) those interest rates that are too low or too high (too stiff, people) are not applied all that evenly across that wealth spectrum. Yes, the vanishing spread and the now familiar presense of the inverted yield curve making it difficult to save and invest.
For some only.

[anne]

This last decade, these years since the long term interest rates began to decline in March-May 2000 has been a transparent and fine investment period even through a fierce bear market in selected growth stocks and through an extended Federal Reserve tightening sequence.

[anne]

Notice, by the way, how relatively dominant value has been. By value, the reference is not to dividends by simply to relatively low price to book ratios. But, general indexing has brought American investors fine returns even through a deep and extended bear market. Cautious investing, even through such a decade, has been attractive, which raises the questions of why household saving-investment has not been higher and why, beyond a gambling wish, institutional investing has been hedge fund driven at such expense.

[Movie Guy]

Note today's economic trend info from the Richmond Fed.

[Winslow R]

robert wrote: "p.s. If you answer "the PBoC & BoJ", you should be prepared to answer "why" to get your Kewpie doll..."

My answer would be the PBoC as to the 'why' they still have the desire to maintain a fixed exchange rate.

I like your market overview but have to wonder if the equity market expects just enough money sees the light of day to keep the economy rolling along.

Perhaps the PBoC will end up having not only their interest in mind but our's as well and gently slow the rate they save. Does't look like it's working so far but the Graham/Schumer vote should push in that direction. I don't recall why but I had Sept 30th in mind as the 'drop dead' date to show some action in yuan/dollar exchange rates. If not, the Fed will likely have to ease soon if a recession is to be avoided.