Tim Duy's Fed Watch: Fed Still Looking Through the Slowdown – Should You?

Tim's email says he is "a bit contrarian" in this one. Agree or disagree, I'm sure he'd like to hear you reactions:

Tim Duy: Fed Still Looking Through the Slowdown – Should You?: The spate of weak data has been well covered in a variety of places. David Altig presents some unsettling history, Jim Hamilton shares the rational concern over the path of core capital goods orders, with Menzie Chen following up on the implications of the 4Q06 GDP revisions, and Nouriel Roubini sticking to the hard-landing story. A pretty grim look at the data; indeed, the durable goods numbers have unsettled my sleep of late. (Interestingly, I would have expected a much worse ISM number given the read on durable goods. We just are not seeing the strong below-50 plunge consistent with a recession. Yet.)

Still, while acknowledging the downside risks to economic activity, Fed Chairman Ben Bernanke threw cold water on the idea that a rate cut was imminent in his most recent Senate testimony. The Fed continues to stick with its call of moderate economic growth (note that “moderate” appears to be around 2%, which suggests, as I have commented before, a not small lowering of potential GDP estimates) combined with easing inflationary pressures, with the possibility of greater than anticipated inflation still the predominant risk to that outlook. I admit to being sympathetic to that view, partly in response to the yield curve, partly on the mixed nature of the data.

But isn’t that yield curve still inverted? Yes and no. Something interesting happened recently. If you focus on the spread between the ten year and fed funds rates rates, you might have missed it. I tend to focus on the ten-two spread, which has been signaling a period of relatively soft growth and an enhanced risk of recession. I keep an eye on a simple probit model that uses this month’s spread to provide an estimate of the probability of recession in 12 months. Note that is not the probability of recession within the next 12 months. It makes a difference to me whether the recession is next quarter or four quarters from now. Also, I stick with a rolling forecast, not fitted values. The model predicted a period of substantial weakness beginning early 2007, with a 52% probability of recession in November of this year:

Through the past year, the ten-two spread has never been deep enough to signal much of a conviction that a recession is a foregone conclusion. The deepest inversion recently was 15bp in November. In contrast, March 2000 – exactly 12 months prior to the NBER dated recession – saw a 27bp inversion that grew to 41bp in April.

Interestingly, the ten-two spread steepened in March in the wake of not insignificant market volatility. My initial interpretation was that market participants saw a Fed rate cut as a foregone conclusion at that point. But throughout March, that expected rate cut was pushed further into the summer, and conviction about the cut has waned. Yet, last Friday, the spread stood at a positive 6bp, which yields a roughly 20% chance of a recession in March 2008 (I will recalculate when the Fed posts the March average for rates). In other words, if the steepness in the ten-two spread holds, it is signaling that economic weakness will be mild, short-lived, and largely dissipated by the first or second quarter of next year.

Alternatively, my initial interpretation that a rate cut was seen as a sure thing may be flawed. It may be that a rate cut is not necessary to stave off a recession. Instead, market participants were just waiting to take out the last remaining chance that the next Fed move would be a rate hike (although it was tough to see a hike in the imminent wake of the problems in the subprime market).

Another alternative is that while the bears are having a field day with some recent data, market participants have their eyes on the rebound in commodities such as metals and oil. Moreover, notice the sharp gains in the Baltic Dry Freight Index – not exactly a signal of impending recession. And while we get another read on the labor market this Friday, the fact that initial unemployment claims stubbornly hover around the 300k mark suggest that the status quo remains in place. Also, despite expectations for a collapse in consumer spending, the February PCE report revealed that real consumption growth is on track for a 3.3% gain in Q1 (I admit to being surprised on the consumption front, as I have been looking for growth in the 2-3% range). Maybe the March number will turn that around; we did see weakness in consumer confidence.

Bottom Line: Much of the recent data are weak, no doubt about it. Growth has slowed, plain and simple. And any optimism I see in the yield curve could be dissipated with Friday’s labor report. Or, as another Fed watcher once put it, it could be a case of Stockholm Syndrome, in which following the Fed forces you to think like them. But in any event, Bernanke & Co. are sticking to their guns, still looking through the downturn and downplaying the risk of recession. With so many ready to call the Fed wrong, it is worth thinking about the possibility that they are right.

Comments

[sa]

it's an interesting time ahead for fed watchers.

[anne]

Notice that clever investors always assume the Federal Reserve is right since the Fed is continually able to create conditions for its being right. Fighting the Fed has long been a way to be poorer. There may come an exception, possibly this cycle, but there will be time to react when it is clear there is an exception. So far, the resilience of the domestic economy echoes an international developed economy resilience that has been pronounced for a decade.

[ken melvin]

When did the recession begin?

[calmo]

I wonder how sturdy that international economy will be without an American consumer, anne.
The Commerce Dept tells us that the paper tariffs against China are only the beginning of what might be generally higher domestic prices --at a time when oil prices and consumer's capacity to spend, (house prices) are diverging.
The housing issue is still central from where I sit, and the Fed will eventually own up to admitting that they think like me on this matter (the UnStockholm Syndrome) when the scale of the housing correction is undeniable. MEW is a large cushion but those recent PCE numbers cannot be supported long term.

says...

Oh, by the way, I really really really do not care for expressions or metaphors such as Stockholm Syndrome in discussion that is completely unrelated to hostage taking. Enough with violent imagery, which confuses actuall violence and mere virolence or propaganda. Have we not enough violence in Iraq each day? Or, is Iraq only a walk in the summer in Indiana through a sate fair, as we were so happily told this weekend?

[anne]

Darn, I switched computers and this machine did not like my complaining. Sorry. the complaint was generic, not specific really, but I do not like using violent imagery were there is no violence being spoken to.

As for inflation, I am surely not concerned; more so slow growth, but not inflation.

[Bruce Webb]

Gold Bugs, bears and shorts are almost always right. Eventually.

It's the carrying costs that eat them up. But their base model may be breaking down.

There is always the right time to exit a market. Ask Mark Cuban. And certainly even a blind pig chances on an acorn once in awhile. But there is a difference between crash and correction. I sense that in housing we are in a correction. People have been adjusting their market behavior against a constant background of people arguing "bubble".

Isn't that how it is SUPPOSED to work? Fully informed market participants using known demand and known supply to set price?

The last recession was extraordinarily mild, to the point that it was not clear in real time that it had started and still at this point in dispute as to when it started and stopped and that dispute colored by the politics involved.

I argued at Calculated Risk several months back that it would be ironic if in response to his reasoned arguments of housing been overpriced and the market overheted that the market listened, reacted appropriately and then dismissed his caution after the fact. Though there is some dispute now there is no question that the consensus over there was for Roubini style hard crash. But what if this Internet thingy works? Regular travelers through the tubes of the Internet are simply bathing in a sea of information, should we be surprised if some of it is sinking in?

Maybe the theorists out there can help me out. Shouldn't it be the case that in a perfectly informed market that hard crashes are impossible? Bears, shorts and gold bugs live in a reality where you make big money in a "killing", each assumes that you can exploit an asymmetry in information: "There will never be a better time to buy gold. Gold is set to explode to ...." Well not if everyone already knows and understands the information.

What happens when people start listening to Cassandra?

[john c. halasz]

"There is always a right time to exit a market." Just ask Blackstone.

[calmo]

I think Tim's citation of another Fedwatcher's reference to the Stockholm Syndrome is helpful (yes, ingenious in the end, not disingenuous) and not gratuitous or distasteful (even in light of the current 15 British hostages).
I think there is a lot behind that idea "in which following the Fed forces you to think like them." --invites you into thinking like Tim who is following somewhat closer...and also invites you into thinking like anne who may not be somewhat closer to Fedwatching but who is undeniably sensitive/close to the violence in Iraq and the current British hostages in Iran.
Maybe that's it: the difference that a forum like this presents is invitational --we can go elsewhere for other opinions and express/withhold opinions, unlike the Fed releases which do not look for replies, which reduce one's responses to critiques --that are forced to adopt the terms and structure (the thinking) of these releases.
Strangely enough, I see this largely because of anne's observation that Tim was a tad insensitive

[reason]

Bruce Webb...
Shouldn't it be the case that in a perfectly informed market that hard crashes are impossible?

I think that it depends how hard the information is. As long as there is uncertainty, and that uncertainty can eventually disappear as new information arrives, there is always the possibility of a sudden change in the apparent equilibrium.

Surely the internet bubble itself argues against your thesis, or are I missing some subtlety in your argument. Relatively small differences in perceptions can have big impacts where large exponential growth rates are in play.

[reason]

Anne,
you are right about the surprising resiliance of the international economy. But until we understand fully why that is, be wary. The past is not always are good indicator of the future, just ask a passing Solomon Islander.

[anne]

Clever response, Calmo, though I am not altogether convinced and generally tend to read elsewhere when I find such crude expressions for I have found the expressions almost always mask irrelevance.

As for the response of Reason, I really do not know why the evident adjustment process has been so smooth, becoming increasingly smooth here from 1980 and seemingly through the developed economies. Notice too China and India and the ways in which growth limitations are continually being overcome. This is important and has been reliable, but the process is not clear enough to me.

[Bruce Webb]

"Surely the internet bubble itself argues against your thesis, or are I missing some subtlety in your argument."

Oddly enough most of the growth in the Internet as disseminator of information has happened since the internet bubble popped. How many blogs existed in 2001? And more to the point how many econoblogs existed at that point?

Angry Bear started in Feb 2003. http://www.angrybear.blogspot.com/aboutAB.html
Calculated Risk's archives start with January 2005 though I am thinking the blog exisited earlier. This blog says it started in March 2005. DeLong's place was around well before that. And Sawicky has been around a long time too.

But in 2001 there were not that many places to play. And the level of information at least as posters were presenting it was pretty dismal, certainly on topics that I knew anything about.

I guess I am suggesting there has been both a quantitative and qualitative boost in available and accessible information about the economy in the last six years. And certainly there has been an expansion in the ability to challenge the dominant narratives.

Are we collectively smarter than we were when the .com crashed? No, did the Internet wither away, did all of those business models simply vanish into dust? Post boom did the Internet turn into a ghost town? Well no. Instead we are rapidly approaching Web 2.0.

Will the iPhone change everything? Probably not. Will it mean me leaving my laptop at home most of the time? Yep, I have the suspision that is going to turn into a $2200 doorstop.

Its like the song. I feel the Earth moving under my feet. As a small kid I visited Disneyland in maybe its third year, I visited the Seattle World's Fair and rode the monorail. For that matter I watched the Jetsons on TV. I also read Fahrenheit 451 and 1984. A lot of that projected reality, both the cool stuff and the really scary stuff is all of a sudden manifesting itself, in a lot of ways the 21st century is living up to the promise that 21st Century/Fox made (before it went Faux).

TIA. Total Information Awareness. It is not just the Right's proposed tool to control us, it is not a bad description of where we potentially could be sitting in regards to publicly available information. Which as it relates to the economy is going to be most of it.

I think the Housing Bubble will be a test. In my view it experienced a Heisenberg moment, the very fact that it was observed started to change its outcome, predictions of meltdown and spillover led market participants, or some of them, to start modifying behavior. Which is what theory would suggest.

I may be a loony, certainly you can get people to agree to that proposition. But just between you and me I think the iPhone really will change everything. I don't think we have even begun to understand what it would mean for everyone to carry a broadband internet connection with an actual usable screen in their pockets. Combine that with some of the stuff the Japanese are doing with their cell phones these days
http://www.japaneselifestyle.com.au/culture/japanese_cell_phone_culture.html
and you end up in a place very different from Dick Tracy's TV watch.

Back in 1985 I paid $400 to buy a ten pound floppy drive reader for my Mac. Because oddly enough I found that the single 400k floppy drive that came built into my Mac with that screaming 128k of RAM wasn't quite enough to allow me to write my grad school papers. You got tired of swapping. I have a 512 MB flash drive built into my watch that I don't even use.

I spent 17 years working in a University Library. I know exactly what it would mean if you could take those five million books and countless documents in Berkeley's collection, combine them with all of the audio and video tapes, and then include the collections of the rest of the world's libraries and give everyone immediate access to all of it at anytime anyplace through your cell phone. And we are this close to that.

It is not all good. I read '1984', for that matter I know who and what our current Attorney General is. But for the limited universe that is understanding the current economic market I think that technology is right on the verge of enabling us to be the universally informed market martipants that economic theory already assumes we are. And the logical result of that should be the smoothing out of all economic cycles.

[calmo]

I feel the Earth moving under my feet.
Carol King...
Such an odd detail to fasten upon out of that jungle of a post Bruce, but what could I do, this tune starts running around in your head and I am out the door barefoot...

[spencer]

One way to look at the bounce in commodity prices is that the US economy is slowing significantly, but essentially every other economy from Russia to Luxembourg is still experiencing strong growth. If the strong commodity prices are due to China and India it may not carry their usual message for the US economy.

The year over year change in real US nonpetroleum imports is approaching zero, so we are already starting to see how the rest of the world does without the pull of the US consumer.

[Dave Iverson]

Bruce Webb... Shouldn't it be the case that in a perfectly informed market that hard crashes are impossible?

Woody Brock might reply: … In reality, we live in a messy world in which securities markets are woefully incomplete—and always will be no matter how many more hedging instruments are developed. [This is a theorem.] And we live in a non-stationary environment marked by ongoing structural changes. In such environments, agents cannot know the true probability of all future events, and thus are regularly wrong. By virtue of both being wrong and being incompletely hedged, they can and do go bankrupt. As a result, systems meltdowns can and do occur. Worse, leverage can amplify such meltdowns.

The prospect of a meltdown is spookier today than it used to be. ...

Bruce Webb: I may be a loony... But ... I think the iPhone really will change everything.

Here are two very good UTube videos (5 minutes each) to support your assertion:
Did you Know?
Changes in technology and society caused by the shift to Web 2.0

And then if interested here is an hour-long Podcast interview with Wikipedia author Dan Tapscott that will seal the deal.

[gab]

Good work - I love that Baltic Dry Index.

[synthesis]

Bruce...

Consider the following words of wisdom:

"Open your mouth and you have already lost it."

[dryfly]

Duy errored. PCE isn't on track for 3-3.5 gain in the first quarter. But 1.5%-2.0. He is making a classic error in numbers.

[calmo]

dryfly sends me scurrying for numbers:
http://www.bea.gov/briefrm/pce.htm
which definitely shows slowing, but Tim is referring to the last nominal numbers (not correcting for inflation), no?
But I hasten to add that I just feel that Tim is beyond making classic numerical errors...so you expand dryfly.

[Tim Duy]

Actually, I don't believe I am above a calculation error, but I don't think I made one here. Q4 real PCE was $8,195.9 (SAAR). The average of Jan. and Feb. was $8,261.9, an annualized change from the fourth quarter of 3.3%. If you assume no PCE growth in March, then the first quarter average will be $8,264.2, or an annualized rate of 3.5%. A quick and dirty check is to look at the monthly percentage changes for Jan and Feb real PCE, which were 0.3 and 0.2, an average of 0.25. Those, however, were the rounded, headline numbers. The actual figures are 0.33792 and 0.1756596, for an average of 0.2567898. Multiple the average monthly rate by 12 you get an approximate annual rate of 3.1%

The strong showing in January helps support the quarterly growth. Definitely a slowing in February. I might have phrased my sentence above better regarding what was revealed by the February report; what was revealed was positive growth. Annualized, real PCE grew 2.1% in February, close to dryfly's range.

Nor does a strong consumption reading preclude a soft Q1 GDP report overall, especially given what are expected to be weak nonres investment figures (which, as Spencer notes, maybe somewhat offset by the flattening nonpetroleum imports).

No guarantess that March will be weak for the consumer; the month looks to have ended strong based on the weekly chain stores data, up 0.3% for the week. See http://www.marketwatch.com/news/story/weekly-chain-store-sales-up/story.aspx?guid=%7B099BB81F%2D5AED%2D4C64%2D9776%2D104D5D39BD1E%7D

[Alex Grey]

Nominal (actual selling prices not adjusted for inflation) house prices are actually down y-o-y (according to the Case-Shiller Index y-o-y changes are now negative). The last time this was the case was in the housing bust of 1990. There are three possible scenarios this time around, two of which are pretty gloomy:
i) First the optimistic scenario – the y-o-y decline in nominal house prices will stabilise or even reverse itself. This seems unlikely given ongoing news about the housing market.
ii) We are in the early stages of a 1990-style housing slump – quite possible and pretty dire.
iii) Given low inflation rates, shifts in housing demand are much more likely to lead to declines in nominal house prices. So the y-o-y decline we are witnessing reflects a modest shift inward in the housing demand curve. This too does not bode well. A fall in nominal house prices means a fall in homeowner’s equity. This is particularly true for recent home buyers. For example, in 2005 73.4% of mortgages originated for 75% or more of the property’s value. Taking the cities in the U.S. with the largest y-o-y price declines,(Boston -5.6% and Detroit -6.9%) the loss in equity for a recent purchaser has been in the order of 20% plus. Nominal house prices are all the more important because people are now relying much more on house price appreciation to do their savings for them. So look for a sharp drop in consumer confidence this spring as the housing resale market starts to send more bad news about house prices.

[Kenneth Klarich]

I would be careful about using the recent increases in the Baltic Dry Freight Index as an indicator of world growth. A large portion of the recent increase in freight rates is a result of port congestion in Australia. Nearly 10% of the Capesize fleet is waiting, up to 3 weeks, for a berth. This has been significant factor in the recent rise in freight rates.