Fed Watch: And So It Begins

Tim makes a bold call on the outcome of the Fed's rate setting meeting:

And So It Begins, by Tim Duy: The Fed begins a two-day meeting today, with market participants widely expecting a rate cut. I am mentally prepared to be on the wrong side of this call, joining the lonely few, but I just can’t tease another rate cut out of the incoming data.

In my mind, the argument for a rate cut hinges on one crucial assumption – that the market is expecting a rate cut, and the Fed will not want to disappoint. From Bloomberg:

''The Fed is reluctant to ease,'' says Louis Crandall, chief economist at Jersey City, New Jersey-based Wrightson ICAP LLC, a unit of ICAP Plc, the world's largest broker for banks and other financial institutions. ''But it also doesn't want to unsettle the financial markets unnecessarily.''

If the Fed fails to ease, so the story goes, they will be blamed for failure to communicate effectively. After all, given their push for transparency, shouldn’t they make an effort to send a signal when the markets are headed in the wrong direction? The problem with this view is that Fed Chairman Ben Bernanke does not believe it is his job to lead markets around by the nose like his predecessor. I think under the new regime, the Fed expects their comments to be taken at face value. And I think they are pretty effectively communicating their view on the economy: Outside of housing, there is minimal spillover, and whatever spillover exists is completely expected. From Bernanke on October 15 (italics mine):

Since the September meeting, the incoming data have borne out the Committee's expectations of further weakening in the housing market, as sales have fallen further and new residential construction has continued to decline rapidly. The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year. However, it remains too early to assess the extent to which household and business spending will be affected by the weakness in housing and the tightening in credit conditions. We will be following indicators of household and business spending closely as we update our outlook for near-term growth. The evolution of employment and labor income also will bear watching, as gains in real income support consumer spending even if the weakness in house prices adversely affects homeowners' equity. The labor market has shown some signs of cooling, but these are quite tentative so far, and real income is still growing at a solid pace.

A week later, Chicago Fed President Charles Evans reiterated the outlook:

Indeed, on balance, I would characterize the data we have received on the real economy since the last FOMC meeting as supporting our baseline forecast.

Such comments – that the economy is roughly in-line with the Fed’s forecast – are essentially ignored by commentators. Has anyone noticed that the data flow has steadily caused 3Q07 estimates of growth to be raised above 3%? Think about it – the Fed cut rates 50bp during a quarter in which growth topped 3%, just after a quarter with almost 4% growth.

The Fed is never that proactive. Never.

Yes, I know, forecasts for 4Q07 are low on the potential impact of the August market turmoil. But note that we have almost no data on the 4^th quarter to assess the quality of those forecasts; largely some volatile data on consumer confidence and jobless claims. Moreover, the Fed expects weakness, and is trying to look through it to mid-2008. And the Fed already cut 50bp because they knew that they would not have any good data on which to assess the 4^th quarter at their October meeting. Nor would they normally commit to policy with only a single month’s data. The month is not even over! That was the “risk management” portion of their decision to cut 50bp in September. How many rate cuts do you take as insurance?

And, on risk management, Fed Governor Frederick Mishkin, one of the architects of 50bp move, sees financial conditions improving:

''Market functioning has certainly not yet returned to normal,'' Mishkin said in a speech at a seminar commemorating the 1907 U.S. financial panic, which led to the Fed's creation. Still, Fed actions ''have helped improve conditions in several short-term funding markets and instill confidence in investors that liquidity would be available if needed,'' he said.

They did not expect conditions to return to normal overnight; they are simply looking for things to be moving in the right direction. And they are – notice that the ABX market is coming unglued again, as documented by Calculated Risk, but the impact on financial markets is considerably more muted than this summer.

I also believe that this latest jump in oil prices will cause Fed policymakers to question their confidence in the inflation outlook more so than the growth outlook (if economic activity was really coming unglued, oil consumption should be slowing). And notice that despite a softer near term outlook for the economy, FedEx is still prepared to boost its air rates 6.9% next year, following this year’s 5.5%. They must be pretty confident of their pricing power. In my mind, the entire commodity complex is a worrying signal about the path of inflation, but I doubt the Fed is as concerned. Likewise the Dollar; I still have trouble believing the Fed has completely written off the Dollar, but continued rate cuts would signal that the Greenback remains a one-way bet.

Finally, I think analogies to the 1998 rate cuts are missing a key ingredient. Then, the world economy was teetering on the verge of collapse (perhaps a bit melodramatic, but you get the idea). Today, the global economy is in the completely opposite condition, this time dragging the US along and helping to offset a portion of housing weakness.

If the Fed decides they are unwilling to defy the market, or that “risk management” requires additional rate cuts, I would have to conclude that regardless of what the statement says, that one must expect a series of multiple rate cuts. They will be responding to the deteriorating housing market, and I simply expect no stabilization in that market in the near future (don’t get me wrong – I am not a pie-in-the-sky optimist).

Finally, if they do cut, I wish they would stop telling us that their forecast is for moderate growth near potential. A rate cut would suggest that they clearly do no believe that forecast.

Bottom Line: I believe the Fed intended to take a pass in October with the 50bp rate cut. I believe market participants were correctly reading the data until they got caught up in the risk management story. I think the Fed has been explaining past actions, not future policy. For that, you need to look at their forecast. On the basis on the data alone, the Fed is already so far in front of the curve it is hard to justify another cut at this point. I absolutely do not expect the Fed to cut 50bp.

This is the most contrarian call I have made; I simply believe that the case for a rate cut is much weaker than market participants appear to believe.

Update: Here's Greg Ip in the Wall Street Journal:

Why Rate Cut Isn't a Sure Thing, by Greg Ip, WSJ: The market is convinced the Federal Reserve will cut interest rates tomorrow, but for the Fed itself, it is a closer call. ...[F]or policy makers, the decision is between the quarter-point reduction and no cut at all. A half-point cut is unlikely to get serious consideration...

Both courses of action have risks. Perhaps the biggest is that the market's certainty that rates will be cut creates a burden on the Fed to deliver. Ordinarily, meeting market expectations isn't a goal in itself for the Fed. But the current environment is more fragile than usual...

The Fed can mitigate the risks on either front with its accompanying statement. No rate cut could be accompanied by a statement opening the door to a future cut. A cut could be accompanied by a statement damping expectations of more reductions. ...

The case for remaining on hold comes down to the economic forecast. While housing data has deteriorated further, there is little sign so far that it has spilled over to the broader economy. Fed officials don't appear to have significantly altered their forecast of a return to moderate growth next year. ...

[T]he biggest argument for cutting rates will be market expectations. Fed officials didn't intend to nudge the market to expect a rate cut, so they will have to weigh the possibility that markets are signaling a more pessimistic view on growth and credit markets than the Fed sees. ...

Also see William Polley's "Could the Fed hold rates constant?" and his comments on Tim's post.

Update: The Chicago Board of Trade's CME Group Fed Watch has:

Summary Table
October 24: 86% for -25 bps versus 14% for -50 bps.
October 25: 86% for -25 bps versus 14% for -50 bps.
October 26: 92% for -25 bps versus 8% for -50 bps.
October 29: 2% for No Change versus 98% for -25 bps.
October 30:
October 31: FOMC decision on federal funds target rate.

A graph of the probabilities from the Cleveland Fed is here.

Comments

[jan perlwitz]

I think it would be entertaining to watch the reaction of the financial markets, if the Fed didn't cut both the Fed Funds target rate and the discount rate in this meeting.

Besides that, I don't think it really matters whether the Fed cuts these rates, since these parameters don't have a significant influence on where the 13.8 trillion dollars US-economy is headed.

That the Fed controls the US-economy by moving the Fed Funds target rate or the discount rate up or down is one of the irrational believes in the financial markets and elsewhere, too.

[Danack]

Surely if they cut the rate just a day after the Dollar hit a new low against the Euro, that would also 'unsettle' the market just a bit.

[Dickeylee]

Thank God for Lowe's. They had wheel barrels on sale in this Sunday's sale flier. I got two, that way my wife can help push our paper currency to the store on Saturdays.

[esb]

Sorry, my good man, but in order to properly manage your resources (assets) you must always view the central bank of the USA as the institution that it is and not the institution that you want it to be.

And what it is under BB is what it was under AG but writ large, a "one trick pony" where the trick is the creation of inflation. Inflation is the tool, full employment is the goal.

The investment community has taken the measure of the man and found him to be the con man that he is.

My predictions ... WTIC $100+ ... spot gold $800+ ... and as for food, well, if you are in the lower four income quintiles, then God help you. And this is just the fallout from the October "meeting." Remember, there is another meeting next month and the crude and gold rise shall continue.

Again ... one trick pony. So 4.5%.

[mark]

The Fed is probably a lagging indicator on the downside because the demand for funds is already low.

I just wish they would tighten money supply growth on the upside rather then be accomotative during a bull run.

[anon.fedwatch]

It is bizarre that you reject the 'risk management approach'. You prefer the rear view mirror approach?

There will be a 25 basis point cut. This will be the second stage in a two stage preemptive cut of 50 followed by 25 basis points. This is justified by real economy risks that flow from financial risks that precipitated the first cut – i.e. the real economy effects of the ARM market, which is due to start repricing in size in coming months.

The choice then is 0, 25, or 50 basis points. It shouldn’t be 0 for the above reasons. They can’t risk a full stop at this early stage. It shouldn’t be 50 because the Fed can’t afford to front-load too much easing, given the risk they may need additional unutilized capacity for future easing under certain scenarios. They need more room to move down further if necessary, given the risk of credit and/or economic event(s) that put deflation risk back in play. Also, they don’t want to send a false signal to the market in terms of a high momemtum easing program. This would create dangerous expectations, particularly for the dollar. So it should be 25. This leaves the option open to continue with more later if necessary, at a pace hopefully more synchronized with incoming data. This will be combined with strong language that dampens expectations of future cuts.

[anon.fedwatch]

And the dollar will rally following a 25 basis point cut with 'tough love' language from the Fed.

[kharris]

Tim Duy refers to "the data" rather than "economic conditions". That may be a mistake. Fed officials have made pretty clear that they are not limiting their attention to the data because they don't think the data tell them what they need to know.

Anon.fedwatch is, I think, making a similar point in reference to "rear view mirror." I would disagree, however, with Anon.f's notion that the Fed will want to hang on to basis points for potential later use. The current theory is that getting the job done as early as possible reduced the amount of overall easing (tightening) that will be needed, and reduces the amplitude of swings in economic performance. Mishkin said something along those lines over the weekend. He said "the more quickly liquidity can be provided when financial instability occurs, the more effective it may be."

There is also a considerable record of commentary from Fed officials suggesting that overshooting in policy adjustment is preferable to undershooting. The momentum in the economy in either direction provides a buffer against bad consequences from overshooting, allowing the Fed to reverse course without much harm. The risk now is to the downside, so the Fed can most safely overreact by easing too much. The bigger risk, according to what seems to be the Fed's own current theory of operation, would be in easing too little.

A well-anticipated ease would already have pulled the dollar down. A 25 bp ease is well anticipated. A 50 bp ease is not. Lots of other things will be going on, but all else equal, the dollar should not diverge from its recent course on a 25 bp ease. As Anon.f suggests, the statement will probably have as big an impact in market responses as the rate decision.

[Bob Brinker]

One item worth mentioning is the fact that core inflation has fallen more than 70 basis points in the past year. This alone argues for a rate cut of 25 basis points just to maintain the same monetary policy stance. In reality, not cutting the nominal rate at a time when core inflation is declining has the same effect as tightening policy. Janet Yellen has been making this same point in recent speeches. Another 50 basis points or more in cuts are likely needed if the Fed wishes to stimulate economic growth. Lastly, the 2008 Presidential election is looming and the Fed may be motivated to get their work done as soon as possible to avoid the conflict-of-interest associated with monetary policy changes during the election season.

[anon.fedwatch]

I quite agree with kharris’s comments generally. Another way of thinking about the Fed's preference to front load policy easing (e.g. 50 basis points last time) is the degree to which they can afford to be preemptive. The quantity is a judgment call of course - otherwise, they'd front load cutting the entire fed funds rate. So in predicting their next move, one has to form a judgment on what this judgment call will be. Are they already finished with front loading/preemption? Tim Duy's recommendation would be consistent with a view that they are. I think not. The complete move from 5.25 to 4.50 is the right move in this regard I think. By moving another 25 bp on this basis, it sort of validates their first 50 bp move (if they'd only moved 25 bp, where would they be now?) They want a certain degree of ease in the system well before the start of the major ARM repricing volumes, because these are likely to coincide with a broader knock-on effect for consumption, more so that the subprime fallout to date. But given the subprime behavior so far, they have to be thinking about the probable effect of having raised the funds rate from 1 per cent to 5.25 per cent on the general ARM population, and what degree of relief that now requires on an anticipatory basis. I think 4.50 puts them in a comfortable position (as far as its possible to comfortable) in terms of the best response to these conditions. Also, I think the Journal article today is effectively a Fed plant to get the market off the 50 basis point probability rather than point it more directly to a 0 bp probability.

[anon.fedwatch]

And my idea that the Fed will want to hang on to a funds rate reserve for potential later use is premised on the notion that the circumstances under which they would need it would be credit conditions much advanced in their deterioration beyond the current situation - i.e. some truly worst case outcome for opaque securitization exposures. I would view the first 75 basis points as being reasonable insurance for a 'reasonable' worst case based on how it looks now, but not necessarily for the 'worst worst' case. This is like delta heding for policy risk. Further credit market deterioration could produce severe gamma events requiring another distinct event of preemptive Fed easing.

[anon.fedwatch]

correction above 'delta hedging'

[Dickeylee]

I guess most economists must have their Guatemalan maids do the grocery shopping, or at least Bob Brinker. "Core" inflation is down? Half priced plasma TV's for everybody! Monday, 10/29, Gallon of vitamin D milk $4.39, one dozen grade A eggs, large, $1.99, loaf of bread, $2.89, 5lb Russet potatoes, $3.78, etc...but if it's too volatile for us to consider in calculating "core" inflation, then what? Too bad for the poor? Oh, right, that's the Republican mantra, isn't it? And oil just hit $93/bbl today, but what the hell, that's doesn't affect "core" inflation either.

[richard]

There is, I think, a political argument to be made here as well.

Actions taken by the Fed today will have their impact six to twelve months out, maybe longer. That "landing period" for actions taken today is going to be right in the middle of the 2008 campaign.

If you're cynical, you'll believe that the Fed is doing its best not to create a more adverse environment for Republicans in 2008. But even if you're not quite that cynical, you might believe that the Fed will try to do everything it can to avoid charges of cronyism, steering a course dictated by data and market expectations.

[spencer]

Everyone here is making valid points, and that is the problem. Because of these conflicting indicators and arguments I come down on the side of a 25 basis point cut, but am not going to bet the ranch against either of the two alternatives.

[Patricia Shannon]

esb says...
Sorry, my good man, but in order to properly manage your resources (assets) you must always view the central bank of the USA as the institution that it is and not the institution that you want it to be.

And what it is under BB is what it was under AG but writ large, a "one trick pony" where the trick is the creation of inflation. Inflation is the tool, full employment is the goal.

Really? I remember being out of work in a severe recession, because Alan Greenspan was intent on setting interest rates to protect against inflation by increasing unemployment. I noticed that he didn't help guard against inflation by giving up his job! I really hated him!

[adriang]

There are conflicting indicators based on which one could lower, stay put or even increase the rate. For all the trouble, the economy is proving to be awfully resilient - we are still within a good day's run of 14000. The truth is that most people fear what-if scenarios rather than reality - current earnings.
I would not place such high profile on the exchange rate. It is not necessarily true, that it affects our standard of living as long as we increase our spending on local products ... and that we certainly do. I would look more at the effects upon the Holiday spending/season and planned production. If the Fed action fails to meet expectations, aside from the hit to the equities market, we will see production of consumer goods that is scaled back, adjustment in future earnings, increased in unemployment for the Holiday season and a likely intervention from the White House. While some may claim that the President of the US does not meddle in these situations, rest assured there will be some sort of a message to the Fed to ensure their head is screwed on straigth.
My bet is for -25bps to soothe the credit markets. 50bps would pump up the inflation concerns.

[jan perlwitz]

Patricia,

are you certain it was Alan Greenspan's fault that you were out of work during a severe recession?

[Patricia Shannon]

jan perlwitz, I would say the recession was prolonged because of Greenspan's actions.

[Patricia shannon]

And Greenspan himself stated that his actions were designed to prevent inflation by keeping unemployment from falling what he considered to be too low. This was during Bush I's reign. I remember because I wrote a song about it.

Surplus Goods
copyright Patricia M. Shannon 1996

Won't you please give me a job,
I've been out of work so long,
I have used up all my savings
and they foreclosed on my home.
I had paid ahead by four years,
but it didn't count at all;
the mortgage company now does own it,
well there ought to be a law.

I was never a big spender,
I paid off loans ahead of time,
I did just what they told me,
saving for when I retired.
I have gone on few vacations,
and at K-Mart I did shop.
Might as well have been a spendthrift,
'cause my credit is all shot.

I went at least for six months
without a single interview,
made worse by new age so-called friends who said,
"You never should be blue."
There's a special place in hell
where there will be sent
George Bush and Alan Greenspan
and Redstone Federal Credit Union president.

"You have too much experience,"
that is what they say.
They want somebody younger,
who won't expect much pay.
Well, I've always tried to work hard,
and to do the best I could.
Now they tell me I'm not needed.
I'm just worn-out, surplus goods.

[Patricia Shannon]

It turned out the poem would fit well with the 2nd George Bush, also

[esb]

What "industry" employed you and what were the approximate dates of your unemployment(s) during the AG years?

[Patricia Shannon]

Computer programmer/analyst. The poem was about the period from 1990-1992.

[esb]

P. S. ...

Southern California, perhaps?

[Patricia Shannon]

It was Huntsville, Alabama.

Correction to the poem/song.
the mortgage company now does own it,
should be
the credit union now does own it,

Actually, the mortgage company didn't want to foreclose. The Redstone Federal Credit Union paid off the loan with the mortgage company, then foreclosed. I had paid ahead 7 months with the credit union. I had always paid off loans with them ahead of time in the past.

[Sandman]

Sorry, but 3% growth in quarter III? Nope, nada and no. You believe those unrevised and bogus government numbers, you "duy" with them. They can either be revised now or in 2 years, doesn't matter. The data does not suggest "3%" growth.

[esb]

P. S. ...

Huntsville ... OK.

Then perhaps what happened to you resulted from the military aerospace depression immediately following the demise of the USSR instead of any monetary-induced effects.

If ever there was a military aerospace town it was (and is) Huntsville.

BTW ... there is a fascinating 1993 film (Michael Douglas/Robert Duvall) dealing with the human fallout from the military aerospace depression of the early 1990s titled 'Falling Down.'

BTW2 ... Huntsville at one time occupied a position on the "top 10" list of strategic targets for USSR ICBMs. Not a top-10 list that I would want to be on.

[jan perlwitz]

Patricia,

How would you know that is was Greenspan's fault? Well, I suppose the belief that the Fed controlled economic growth and inflation by moving the Fed Funds target rate up or down is one of those "truths" which is repeated everywhere and all the time so that almost no one questions it anymore. All these discussions whether the Fed should lower the Fed Funds target rate and by how many basis points are based on the shared assumption the Fed really has this power. I am asking you because I don't share these believes.

The Fed Funds rate about which everyone is talking these days and at which financial market players stare like the rabbit at the snake is the interest rate depository institutions charge each other for overnight lending of excess reserves to meet their reserve requirements with the Fed. The reserves of all depository institution in USA together amount to less than 45 billion US-dollars. The net borrowing of excess reserves between banks amount to usually less than 2 billion dollars daily. The Fed Funds rate concerns a minuscule money pool compared to the size of the credit markets of trillions of US-dollars and the 13.8 trillion US-dollar US-economy.

So far, no one has given me a good explanation what the causal relationship is supposed to be between the Fed Funds target rate and GDP-growths and inflation. It's like assigning the ability to control the whole US-economy to a single mutual fund with its market activity. The money pool which is targeted by the Fed Funds target rate has about the same size. Is there any scientific proof for this alleged causal relationship? Any observational data which would support it? I doubt that.

[Patricia Shannon]

esb says...
Huntsville ... OK.

Then perhaps what happened to you resulted from the military aerospace depression immediately following the demise of the USSR instead of any monetary-induced effects.

If ever there was a military aerospace town it was (and is) Huntsville.

Yes, but since the whole country was in recession at that time, there were not enough jobs elsewhere.

jan perlwitz says...

Patricia,

How would you know that is was Greenspan's fault? Well, I suppose the belief that the Fed controlled economic growth and inflation by moving the Fed Funds target rate up or down is one of those "truths" which is repeated everywhere and all the time so that almost no one questions it anymore. All these discussions whether the Fed should lower the Fed Funds target rate and by how many basis points are based on the shared assumption the Fed really has this power. I am asking you because I don't share these believes.

Alan Greenspan doesn't seem to share your beliefs, or at least he didn't used to. I don't know if he's changed his mind.

The comments by esb and Jan were made in response to the following comments I made previously:

jan perlwitz, I would say the recession was prolonged because of Greenspan's actions.

Patricia shannon says...
And Greenspan himself stated that his actions were designed to prevent inflation by keeping unemployment from falling what he considered to be too low. This was during Bush I's reign.

It seems to me that the original comments were short and clear, so I don't understand their replies which ignored what I actually said.

[Patricia Shannon]

http://money.cnn.com/1999/05/06/economy/greenspan/

May 6, 1999: 11:06 a.m. ET

Fed chief says record low joblessness will cause prices to rise eventually

NEW YORK (CNNfn) - For months, economists scratched their heads over this bedeviling question: Why hasn't the country's low unemployment led to rising inflation?
Federal Reserve Chairman Alan Greenspan picked up the query Thursday, expressing fear that record low joblessness will cause a rise in prices.
"An increase in inflation doggedly forecast to follow the ever lower unemployment rate--now the lowest in three decades -- has not occurred," Greenspan told a Fed conference on banking in Chicago.
But this rosy scenario, the nation's top banker said, won't last.
"At some point, labor market conditions can become so tight that the rise in nominal wages will start increasingly outpacing the gains in labor productivity, and prices inevitably will then eventually begin to accelerate," Greenspan said.

http://www.washingtonmonthly.com/books/2001/0001.schieber.html

Needless to say, someone intent on taking a critical view of Greenspan wouldn't suffer for lack of material. Take early 1994. Despite few indications of inflation as unemployment fell, signs we now recognize as the rumbling of a new economy, Greenspan's Fed clung to the same model that had informed central banking for years. The key to that model is what economists call the non-accelerating inflation rate of unemployment, the point beyond which further reductions in unemployment tend to trigger inflation, and beyond which central bankers tend to get interest-rate happy.

Of course, the funny thing about a new era is that you don't know it's new while you're in it. At least not right away. Given that ignorance, Greenspan did what any reasonable human being would do: He played by the rules he thought were in place.

Still, as time went on, unemployment continued to fall and inflation remained at bay. As Woodward tells it, this moved some to argue that the traditional model no longer applied, and that a continued drop in unemployment didn't necessarily spell trouble. Yet Greenspan was unconvinced. (In fact, he squeezed one proponent of this view out of the vice chairmanship of the Fed.) The Fed doubled interest rates between 1994 and 1996.
...
George Bush is still convinced Greenspan cost him re-election by raising interest rates in 1991.