Tim is losing sleep:
Runaway Rate Cut Train?, by Tim Duy: I agonize over this stuff. Constantly. And it is not really part of my job. Just can’t get it out of my mind.
It is even more agonizing when expectation flip-flop so strongly, from rate cut to no rate cut back to rate cut certainty. From the Cleveland Fed:
Fed Chairman Ben Bernanke’s speech kicked off a shift in expectations, reinforced by additional Fed speakers. The ongoing risk management theme was reiterated by new Chicago Fed President Charles Evans:
To me, the uncertainties about how financial conditions might evolve and affect the real economy mean that risk management considerations have an important role in the current policy environment…However, there is a less benign possibility. Housing demand and prices could weaken a good deal more than we expect — either because a new shock hits the sector or because we have underestimated the weakness already in train….
I want to emphasize that I do not see this extreme outcome as likely. But it is one of those high cost outcomes that we should guard against. The challenge is to calibrate the insurance in light of the lower probability of the spillover event occurring.
The upshot of such speeches has been to entrench expectations that as long as housing is deteriorating, the downside risks to the economy are too great to be ignored, and therefore rate cuts will continue regardless of the relatively minimal impact the housing downturn has had on the rest of the economy. Still unsteady credit markets argue further for additional cutting.
And, make no mistake, housing is bad. This morning we get existing home sales, which, considering the local reports I have seen, are almost certain to be simply dismal. I did a road trip to Bend last week, and can confidently report that close to half of central Oregon is for sale. Housing of course was the big topic; when will the downturn end, will prices fall, etc. My story of how bubble markets generally end badly, and don’t bounce back for years (look at the NASDAQ, I say), does not make me many friends.
But when I pressed the business community (not realtors – they only tell you to wait two months, prices will be on the rise again) on the environment outside of sectors directly tied to housing, I continuously received the same story – no problem.
Of course, there is weakness outside of housing, but the weakness is exactly where it should be – stress on consumer spending in particular, and related industries, such as shipping. As I have said before, a portion of this stress is being offshored in the form of weaker import growth, while strong global growth is supporting the export growth. I think this is a powerful dynamic at work. Note GE’s Chairman Jeffery Immelt:
"We see orders everywhere around the world that seem to be accelerating and not diminishing," Mr. Immelt said. He said the U.S. economy appeared "OK," excluding housing.
My expectation remains that the US economy will weather the housing rout better than expected, especially given the global pull, particularly from emerging markets. That leads me to believe that we are not on a runaway rate cut train in the US. Indeed, from an inflation standpoint, the last thing the global economy needs is a runaway rate cut train placing further downward pressure on the dollar. Note the WSJ cover story detailing the challenges global central bankers are already facing trying to stem the rise in their currencies while keeping inflation under control.Something has to break.
Based in part on that outlook, I have recently tended to view the 50bp cut as a risk management tool that allowed the Fed to take a pass in October, providing time to assess the impact of the housing/credit market turmoil before returning to the possibility of a cut in December. After all, by the October meeting we will have little insight into the 4th quarter data. And it is tough to believe that the Fed wants to keep cutting rates on the back of a 3% quarter. The cut in September as a preemptive move makes sense given that we really wouldn’t have a good sense of how Q4 is playing out until the December meeting. Moreover, the Fed really could not have expected that the September rate cut would do much for the housing market, nor that the recovery in the credit markets would be anything but gradual. And the part of Evan’s speech that received less attention sticks in my mind:
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. True, housing markets have tumbled further — sales fell sharply in August, new construction dropped a good deal further in August and September, and prices have softened. But the rest of the economy appears to be moving forward. Sales at automotive dealers and other retailers posted good numbers (in real terms) in August and September, indicators point to further increases in business investment, and industrial production has continued to rise. Importantly, according to the revised data, nonfarm payrolls increased an average of about a 100,000 per month rate in August and September — a pace we think is in line with demographic trends and an economy growing at potential.
That said, it looks like I am so far on the losing side of that bet. Uggg. As I said, I will get no support from the housing market, and don’t expect any. Instead, my focus turns to Thursday’s durable goods report. But, if housing fever has seized the Fed as so many believe, a slew of positive indicators in other sectors may have little impact.
Update: See also Wall Street Wants 50, Fed May Give Zip for Now, by John M. Berry