Fed Watch: The Box Closes

Tim Duy says the Fed has painted itself into a corner:

The Box Closes, by Tim Duy: Last time I wrote, I concluded:

Tough times for a Fed watcher – knowing the Fed wants to hold steady, but seeing the box they made closing in around them. It is difficult to see what combination of data and events will allow the Fed to hold steady in the months ahead at this point. The best chance for the Fed to avoid a rate cut (a cut they don’t want) is that both the financial markets remain calm and the August jobs report is very strong.

As it turns out, the August jobs report was pretty much the opposite of strong. Normally, the Fed would wait for another jobs report to confirm the weakness; I think they will see this number by itself as an aberration. Just the day before, as the Wall Street Journal noted, policymakers were out in force with a seemingly choreographed message intended to dissipate expectations of a rate cut. After all, the Beige Book did seem to confirm their contention that the overall damage from recent financial turmoil was limited. And August retail sales are looking considerably better than expected. The ISM numbers held mostly solid. Indeed, the data had been cutting their way. This all, however, is now just dust in the wind.

The pressure to cut is enormous, too much so, I think, for the Fed to resist. Politically, the Fed erred with the August discount rate cut. It was a clear example of academics thinking they are cleverer than everyone else. That action, and the accompanying statement, only entrenched expectations for Fed funds rate cut. They should have known that. Now, given that the jobs report did not cut their way, in addition to pressure from Wall Street, the pressure from Capitol Hill is overwhelming. From Bloomberg:

''A strong response is required -- specifically, a meaningful interest-rate cut,'' Frank, chairman of the House Financial Services Committee, said in an e-mailed statement. ''The deeply troubling August employment report should end any debate about the action that the Federal Reserve Board must take when the Open Market Committee meets on Sept. 18.''

My thought is that for the purpose of maintaining central bank independence, better to look to be driven by the markets than by Congress. Too late for that.

I still believe the Fed will cut only grudgingly. I anticipate the next round of Fedspeak will not be supportive of those looking for 100+bp of easing in the upcoming months. I place better than even odds that we see a dissent this time around. I only expect 25bp. But what about the accompanying statement?  I am sympathetic to William Polley’s view that the Fed will not want to give the impression that another cut is a sure thing, preferring to leave a balanced statement of risks. That is my instinct as well, but I admit to being troubled by it; a balanced statement now I think will make the Fed look foolish after the events of the past weeks, and the fact that the August statement mentioned only downside risks to growth, and nothing about inflation. 

I doubt this will be the only rate cut in any event; we are entering a soft spot in economic activity, and data from the housing sector by itself will be sufficient to maintain expectations that we are all going to die. See the latest news from Countrywide for a sample. 

As far as the economic outlook, I believe one has to make a decision to live in today’s data or tomorrow’s data. Near term, I expect considerable weakness as the housing market washes out. But my year ahead forecast based on the yield curve is telling a pretty clear story; this Fall and Winter will be tough, but by Spring economic growth should rebound:

The math on this is straightforward; just look at the totality of the data.  Typically, the Fed does not initiate a rate cutting cycle on the back of a 4% GDP number. Typically, the Fed does not initiate a rate cut cycle with the ISM manufacturing index above 50 – we used to look for three consecutive sub-50 reads to guarantee a cut. Typically, the Fed does not initiate a rate cut cycle on the backside of an inventory correction. I know it may be tough to believe, but the Fed is not behind the curve; a cut now will actually put them in front of it compared to their usual timing. 

Note also that gold broke out above $700, copper bounced today, oil is poised to make a run for $80, the Baltic Dry Index is off the charts, productivity growth is falling, and the Dollar is set to make another drop.  Moreover, I suspect China will be revisiting their currency/foreign exchange reserve policies after the 2008 Olympics, adding to additional downward pressure on the Dollar. 

In short, I think the Fed is rightfully cautious about the inflation outlook, but policymakers are likely to cut rates anyway. Historians should take note; I have a sick feeling that this is the moment the tide turned on the 25+ year battle against inflation.

Comments

[William Polley]

It's a bit of a lose-lose situation. If they cut 25bp, people will expect more. If they cut 50bp, then people will get the idea that it's worse out there than they thought and the Fed needs to be more aggressive and hence, they will expect more.

But they can control it to some extent with the language in the statement. The goal will be to use language that is the "least bad". "Good" may not be possible. They just can't paint themselves into a corner like they have at times in the past. That would be a hard hole to dig out of.

It's nice to see our instincts are similar. And I admit to being troubled by my instinct as well. But since some of the other possibilities are more troubling, I'm trying to accept it.

[calmo]

Always a pleasure to read Tim's views...but I have my quibbles: Near term, I expect considerable weakness as the housing market washes out. so "Near term" doesn't sound like the next several years to me, but I think wrt housing prices, doesn't that "nearness" --several years, sound about right?
Some nuance and anguish here:My thought is that for the purpose of maintaining central bank independence, better to look to be driven by the markets than by Congress. Too late for that. Somehow I don't think all that many people are listening to Congress, (esp the widely suspect and disorganized Dems as reported by GOP media). If the Fed is not driven by the markets, the latter have the megaphone to register the complaint, but Congress has to enlist that service from a branch of the markets: the media, no?
The Fed would like to hold, rather than face a series of 25 bp cuts, I agree. But the longer this series of cuts (or the deeper the cut) the larger the possibility of that inflation (the serious 25 yr battle being lost) [this could be a tad melodramic, but not for Tim] goes to the moon...all the more reason that the easing will not be done quickly...and the "holding" might be longer than expected.
We'll see.

[Bernardo Aito]

Hi Tim,

I'm not sure the cut will be limited to 25 bp. I think Ben Bernanke may befiguring out that the economy needs a deep correction to make up for several bubbles that have inflated in the past years (not only housing, also the CA deficit). So if only Bernanke was sure that the time for the correction has arrived, he will "help" the correction by significantly dropping the USDollar down (in order to "export" some unemployment). Hence a rate correction in this case should account for at least .5% if not more.

Feel free to vote for the "FED forecast poll" on http://thedailyeconomist.blogspot.com/

Best

[esb]

" ... the 25+ year battle against inflation."

Over the past 25 years the purchasing power of the dollar has fallen by half.

If this is the outcome of the battle against inflation then the battle was lost.

Now it is time for the loss to become a "rout."

At least the fiat money con game will be made clear to a far larger segment of the population and many will have the opportunity to take protective actions.

Oh, and historians should take note of this also: an attempt will be made to "control" inflation by reporting it improperly and inaccurately. That's what managing "expectations" is really all about, inducing people to act in the belief that the "cost of survival" is rising at, say, 2% while it is actually rising at, say, 4%. This new aspect of the con was not yet fully in play in the late 70s. It buys some time but also leads to the same destination ... the cusp of social unrest.

My belief is that a properly functioning government runs an honest hard currency, reports data series accurately and, most importantly, takes the "corrections" (painful though they may be) along the way so as to avoid stumbling into the series of booms and busts which now seem to have captured all of us.

BTW ... the August DataQuick California releases are leaking and to call them "jawdroppers" is an understatement. Calculatedrisk has something up on this and should be noted.

[spencer]

Your Dry docks link seems to be to a pay location.

Try this link for a direct link at no cost.

http://www.dryships.com/index.cfm?get=home

[spencer]

The drop in teen employment in the household survey and
plunge in education employment in the payroll survey makes
me wonder if the way the calender worked this year -- the 31st was on Friday before the holiday -- may be creating problems with the seasonal adjustment for back to school
changes. If the 12th -- the week the data is collected --
is early could this mean that a lot of schools just
hadn't brought faculty on to payrolls yet.

This is not to deny the employment was weak, but an absolute drop is out of line with other indicators.

[spencer]

My version of the Taylor rule says the Fed has room to cut,
but it is more because of improved inflation data than weakness in the economy that my fed policy index has improve.

Until the employment report I did not think the Fed needed to cut, but now I would not bet against it.

[One Salient Oversight]

The US has a rather large current account deficit along with this subprime meltdown. International investors will realise that they're not on a good thing any more. So while you've got the sharemarket volatile, the forex market will be too. A devalued US dollar can only result in inflation, and the Fed has the choice of either letting inflation run out or be brave like Volcker and focus on keeping inflation under control.

Add to this the fact that crude oil production has probably peaked (Peak Oil) and you have a perfect storm.

[eh]

...but by Spring economic growth should rebound:...

Americans taking out home equity loans and using the money to buy stuff made in China at Wal-Mart produces 'economic growth' in the US. What sort of 'economic growth' does the author expect by next Spring, when housing will most certainly not yet have bottomed? Honestly, how long has it been since the US had 'economic growth' that showed up in the real wealth of US workers?

[calmo]

As much as I hate the term "perfect storm", One Salient (but Oversight, not Insight?), I find that view quite compelling.
In the Volcker period, I'd argue that wage driven inflation was a significant component, unlike current circumstances where the salient feature of globalization, union busting, has made this "25 yr battle against inflation" (says Tim) something of a successful marketing job (which Tim may not believe). [See Tim Guy's thread here and see if it ain't so.]
I agree that significant easing might have this result on the dollar esp if LIBOR continues to move up:A devalued US dollar can only result in inflation, But I also think the Fed is aware that easing might have to be substantial --like it was in the tightening period, to move those mortgage rates. They don't want to spoil everyone's high regard for them after all these years of building that magnificent even "Maestroian" reputation, if nothing happens to those long rates after, say, 100 bp of easing.

[Jean]

Why bailout the mess if you don't change the stucture so this can (probably) happen again? A bailout seems like a green light to the lenders: no consequences, wheee, let's do it again!!

[Karl Smith]

I have come around to the position that strong cuts are necessary and I have been slightly more hawkish than the FED for the past couple of years. So on that metric I think we might be in for some cuts.

However, I would tilt the language to focus on the employment data. I would say something like:

While retail sales and production remain strong the data pointed to weakness in employment proceeding the turmoil in the financial markets. This combined with the ongoing weakness in the housing sector posses a risk to growth.

The FED will monitor incoming data closely and is prepared to respond to further deterioration in employment conditions.

[robertdfeinman]

I find all this Fed watching like talking about the weather. Why bother?

If you are correct in predicting the Fed's actions someone will buy you a beer. Otherwise you'll be buying.

A more interesting subject is what should individuals and businesses be doing to protect themselves given the current uncertainty. I'm sure the hedge fund analysts are all tweaking their models to allow for a variety of future developments. How about some of this "expertise" being transmitted to the rest of us?

Oh, right, economists don't give (unpaid) advice, they just stare into crystal balls.

[calmo]

So what are the odds that rdf provokes one economist (Mark) to respond in the next half dozen posts?
A McEwen's scotch ale says he will not rise (like those fat cats refusing to rise to the rats in the pie).
But this B good and nearly alright rdf:A more interesting subject is what should individuals and businesses be doing to protect themselves given the current uncertainty. I'm sure the hedge fund analysts are all tweaking their models to allow for a variety of future developments. How about some of this "expertise" being transmitted to the rest of us? And although hedge fund analysts are a subset of economists, (in the marine sense) [I plug my rare quips until I flag, you?] that is the BAD subset whose pillaging is not for "individuals ans businesses".
Carnage in HFs about to start in my humble and not sociopathic opinion.

[bakho]

With the budget in deficit and Billions destined for the giant rat hole in Iraq, there is not a lot of room for Keynsian stimulus. However, the Federal govenment should be better prepared to bail out the state budgets if the downturn occurs.

[Lord]

Housing is driven by momentum. Failure to halt the momentum now will inevitably bring a recession. If a recession is what the Fed wants, it will get it. Inflation is the result of past policies. We will have some with or without a recession. The question is no longer about a cut, but how significant a cut, and 50 would only put the Fed in neutral.

[mrrunangun]

In terms of gold and oil we already have seen quite a bit of dollar devaluation. Each has roughly tripled in dollar price over the past 3-4 years. The prices of European manufactured autos have reached unbelievable levels when compared to similar domestic makes from the Japanese firms. Same goes for French or German vs. domestic wines. If you've been to Europe lately, I suspect it has become more costly too what with the rise of the Euro against the buck, though its rise is not as dramatic as those of oil and gold.

[Lafayette]

BA: I think Ben Bernanke may befiguring out that the economy needs a deep correction to make up for several bubbles that have inflated in the past years (not only housing, also the CA deficit).

Couldn't disagree more. There is no "deep correction" necessary, since the fundamentals are not all that bad. Not yet, anyway.

This panic is a passing schizophrenia on the part of stock market investors, particularly in the Far East, who think China's exports are doomed to extinction because of the sub-prime mess. The "real person" (on the street) will not restrain spending until they see a serious increase in unemployment, beyond 5%.

Which is possible. But, can we just wait and see rather than "naysaying" the future.

Beware of what you predict ... it could just happen.

BA: So if only Bernanke was sure that the time for the correction has arrived, he will "help" the correction by significantly dropping the USDollar down (in order to "export" some unemployment).

The dollar IS significantly down. What more can it do by nosediving further, except push pump prices skyward? THAT will panic people - for sure, for sure.

Besides exports are barely 7% of the US economy as a whole. They are the cherry on top of the cake and have never pulled the US economy out of recession.

However, profits made globally DO HAVE a direct impact on bottom-line stateside and could deter some companies from further layoffs. (I've seen this happen several times in the IT industry.)

Let's not underestimate the resilience of the American consumer. Not just yet.

Bottom line: We just don't know now how severe this "correction" is going to be. History, and particularly economic history, repeats itself ... but rarely in the way we think.

What stock markets need is to have their "feel good factor" burnished. Some really serious bank failure announcement and the Cassandras will be out in droves. (Misery mavens enjoy not only company, but lots of media attention.)

If demand stabilizes or retracts only slightly in the US and if corporate chieftains keep a cool head and do not lay off people willy-nilly, then the downturn will be shallow and brief.

So, let's all go out and buy something.

[Linda Smith]

I find economic forecast articles complex but have enjoyed being educated by all these comments to this interesting blog post. I live in California and knew the housing market was going to get pretty ugly two years ago. I live in the East Bay area and home values went up to $1+million just last year...talk about giving people "made up" mortgages...no way anyone can make payments or sell their homes. I'm not sure "going out and buying something" is going to help keep inflation away, nor is buying everything China is desperately manufacturing...geez, we're breathing the polluted fumes from here. So...looks like recession, high inflation, job cuts...what more can Santa bring this year?

[apj]

I tend to agree with your sense of foreboding on the inflation front (notwithstanding the data's misrepresentation of reality), but only if the FFR begins by dropping 50bps on Sept 18. That would be a straight line extrapolation of the Greenspan Modus Operandi, about which global markets are sending signals they are tiring.

But they're not going 50bp are they? I don't know what more the Fed must say to convince markets that they'd really prefer not to ease right now....not as a reaction to financial market turbulence. Unfortunately they've been called to action by the Employment data, making an ease almost unavoidable at this point, but by the minimum increment of 25bps surely. The best course of action is to combine this with a cut in the DR by 50bps. Libor is the effective funding rate of the economy, and that's what they have to address. Cutting FFR alone leaves the possibility entirely open of no response from Libor. The DR must be reduced as well to ensure Libor has no business being 5.70%, 50bps over the FFR target. It can't be a surprise that Libor has pulled up just shy of the DR amongst all this mess.

As for the Statement, the Fed simply has to tell it like it is, and not obfuscate or feel obligated to adhere to some rigid and irrelevant formula. There's a problem in financial markets...and here's what we're doing about it. Our view of the economy is "X", and until it changes, it will remain "X". The risks are as follows....etc etc. They will inevitably have to ease for the economy's sake in my view, but based on current data as the post mentions, it's unlikely to begin this process just yet. The market should get a tremendous feel for the Bernanke Fed's reaction function on Sept 18 (though it should collectively know already, quite frankly), and I for one hope it is a little different to the Greenspan Fed.

One thing for sure, 2008 is going to be the year of sweeping regulations, which is a good thing, but not the fuel for a v-shaped turnaround in housing markets and asset prices.

[Lafayette]

apj: I don't know what more the Fed must say to convince markets that they'd really prefer not to ease right now

Let’s look at the Act of Congress that brought the FRS into existence. Here is what the act says about what the Fed should be doing. Don’t look for a “charter”, because there isn’t one. About all that can be found in the form of legal instruction is here:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

Now, where does it say that the Fed must automatically reduce interest rates to reflate the economy, particularly at a time when the economic definition of “recession” is not yet met?

The words "long run" are repeated twice. Why that?

My interpretation: Because it wants to underscore the fact that Fed decisions/actions have tremendous import. And that they should be considered carefully, with a cool head - and not in the heat of the moment.

The Fed already made a number of mistakes, particularly during the Depression - because it listened to "conventional wisdom" when it should have not done so.

[Marta K]

Question from a newbie: How does a fed cut, hold, or raise effect 30 yr treasuries (TYX) and bond yields?

[Winslow R.]

Theory is long term rates are just expectations of future path of short term rates.

I don't find this to be always true.

Reason: In order to raise long term rates the Fed has to be 'expected' to keep short-term rates too low to stifle inflation. Hasn't happened so far even with latest Greenspan prognostications. Current 'flight to quality' also is providing distortion to expected path of short-term rates as very few people think the Fed will drop the fed funds rate over 1% this month, yet the 1 month security says its a sure thing.

If long term rates continue on their current trend lower and can't be sustained above 4.8% by foreign entities shifting purchases into real U.S. assets, I believe without a large fiscal boost we will soon have a recession as 'savings' outweighs the desire to spend.

[calmo]

clinging to Winnie's last gaspI believe without a large fiscal boost we will soon have a recession as 'savings' outweighs the desire to spend.and mulling the implication over that the problem is that we have a savings glut attitude --not that there is no money in the bank, just that it now seems prudent to wait for a more opportune time.
I suppose for the wealthy this might be the case, but for those that had depended on their house as a permanent source of income, it is just a shade or 2 darker than that. [See all those foreclosures? and worse to come they say.} Likewise many who had their life savings in "safe" pension funds...it just isn't all that bright and sunny anymore.

So another cut itiz...which at least gets "the market" numbers up...but at what cost? Some (Setser) are wondering how the government is going to pay for the CAD at the end of the month as the TIC data says the foreign investors have left town. China is complaining that the US is not even trying to support the dollar, so it's hard to believe China will be encouraged to support this negligence by buying tbills.
It is not an easy cut. And when does this "loosening" actually reinvigorate the spent consumer (and not the nearly spent investors)?
Not any time soon, it seems to me. Will we see some legislation as soon as it becomes clear that the Fed is powerless?

[Winslow R.]

"China is complaining that the US is not even trying to support the dollar, so it's hard to believe China will be encouraged to support this negligence by buying tbills. "

Perhaps a shift in 'attitude' in the last few days? China, Abu Dhabi and others may have come to the conclusion that 10 year rates have dropped enough (along with bank stocks) to make them worth investing in again.

I see the Fed as providing enough liquidity to allow the orderly transfer of assets from nonbanks to banks yet an insufficient liquidity to allow nonbanks to become profitable. It is a political line they walk between the big bankers (BofA, Citigroup) and those that had unrealistic desires to be large bankers (Etrade, Countrywide)

[Winslow R.]

Should read..

China, Abu Dhabi and others may have come to the conclusion that 10 year rates have dropped enough (along with bank stocks) to make bank stocks worth investing in again.

[Winslow R.]

I wrote: "It is a political line they walk between the big bankers (BofA, Citigroup) and those that had unrealistic desires to be large bankers (Etrade, Countrywide)"

This is a link that supports the view that the Fed is in it for big banks...

* QUESTION: Kathleen Stephansen from Credit Suisse.

Just thank you very much for this very interesting speech. Just aquestion: You alluded to the discount rate and the stigma that it stillcarries. Would you think that if there was no spread between the discount rate and the Fed funds rate, whether that stigma would disappear?

MR. KOHN: I think if there were no spread, the economic incentives might overcome the stigma. I'm not sure that the stigma would entirely disappear. But I think part of what we're seeing -- if I can sort of reframe your question -- about the lack of use of the discount window is partly economic and partly non-economic or partly about the 50 basis points, but partly about the stigma. And obviously, if we take the 50 basis points away and you can simply borrow at the federal funds rate, in effect I think the funding market would come all into the Federal Reserve. I mean, everyone would be borrowing a lot, including people who don't -- it's a very -- it would be a very difficult thing to do.

There are people who don't borrow at the federal funds rate, right -- smaller, medium-sized banks. And if they saw this window, they would come in and borrow -- basically, we would be giving them funds at a subsidized rate that people don't ordinarily have access at the funds rate. And we would be creating, I think, problems for the open markets, because they would have to anticipate how many reserves are going to be supplied through the discount window, which would be very hard to anticipate, and then drain those through open-market operations.

That's not to say that circumstances might not dictate at some point that we do something more with that penalty. I don't want to take that off the table. I think it's fair to say -- as I kind of hinted at in my little section on liquidity -- that we're looking at lots of different options about how to supply liquidity to the market. But I think we need to recognize that the one you came up with has some costs and some difficulties associated with it.

http://www.cfr.org/publication/14890/