Fed Watch: Runaway Rate Cut Train?

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 4^th 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

Comments

[knzn]

nonfarm payrolls...a 100,000 per month rate...a pace we think is in line with demographic trends and an economy growing at potential

Dude, that's harsh. Who exactly are the "we" to whom he refers? Presumably, if the unemployment rate continues to rise (as I expect), the idea of potential employment growth will change. There have certainly been changes in the labor force participation process, and there will likely be some permanent change in trend, but much of what has happened recently is either transitional or a response to lack of demand. For example, young people have been increasingly choosing to go to school instead of entering the labor force, but the education sector is unlikely to expand sufficiently rapidly to accommodate a continuation of this trend at the recent rate.

[anon]

The engine for global growth has been supported by export-led strategies from emerging economies -- China, India, Brazil, BRIC -- and consumption by the West --the U.S mainly -- enabled by a fixed-exchange regime. The best scenario to unwind this strategy necessitates the role reversals of these two blocks, i.e the U.S will export more while the BRIC's will unpeg the foreign exchange rate to the dollar and allow their citizens to consume more. However, I just can't see a saving culture like China can turn on a dime and become a consuming society overnight. Not to mention the political upheavals that may follow when there are more spending power allocated for each citizen from the emerging nations. Aggregate demand will slack and there will be a slow down to the much-touted global growth in this current paradigm. A new growth paradigm on the horizon? Anyone?

[calmo]

So "non-harsh" used to be 150,000 per month?
And fuggedabout the dismal character of those non-manufacturing jobs (the ones that Tim and GE are pinning their hopes on for that participation in a de-coupled world economy that buoys up US exports).
No, concentrate on the lack of any confidence in any number here with that "illegal alien" population...not to mention its demographic profile.
I'm tickled by Evans remarks here: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. and wish I had the time to cutanpaste his or the Fed's remarks over the past year about this "extreme outcome"...and the transition of "the disintermediation of risk" to "the illiquidity of the credit markets".
The first step in containing any real danger is to notify your patient far in advance, that the slightest shock could be totally disabling. [So you surviving heart patients out there, plug into your life support systems for the rest of this.] I'm not saying the danger is imminent, but you might also want to connect your emergency power unit to that life support...what the hell.
Except that the Fed bank rep cannot invoke religion like that. No, he has to warn without stampeding...now that the pasture is nearly brown and the herd is getting restless...owing to former confidence in "the disintermediation of risk" and the belief in green grass forever.
An excellent, if anguished, report from Tim as always. Merci

[Peter]

Dr. Duy's sanguine outlook perpetuates the corporate trusts becoming richer- while soaring health care costs continue to bleed many Americans.

His global rosy outlook is like 1928- a New paradigm- what happens when third world countries run out of credit to buy our crappy goods?

[calmo]

Peter, there is Dr Duy's outlook for Oct 31 (that Fed announcement) and then there is Chicago Fed Prez Charlie Evans's "sanguine" you call it, outlook intended to pacify (not just those wealthy interests), yes?
I don't think Tim's outlook is "rosy" for us or for the global economy which might be rosier thatn the US's but not as vibrant as "rosy".
You figure Tim should have visited the Sally Anne to get the inside view (those health care miseries) of what the Fed is about to do next week? [Acutally, I find the silence from the Fed about M-LEC deafening, you?]
Me neither...but there are other Fed banks and some more sensitive to the housing correction than others.
Do you have other reserve bank's positions that you think might add/subtract from Tim's post?

[gc]

There is a chart credited to Credit Suisse that shows a two year peak in option ARM adjustments over the 2010-2011 period. It seems like the rate cuts now correspond with a weak dollar. The dollar weakness would tend to inflation risk and higher interest rates. Flat or falling real estate prices and higher interest rates would seem a recipe for putting many of these option ARM holders underwater when they are going to refinance in a couple more years. It seems to late for the Fed's action to make any difference for the subprime blow up. Is the lowering a current fed fund rate closing the barn door after the horses are gone and calculated to insure that they can't wander back into the barn by chance?

[Sandman]

The only problem is, non-farm payrolls aren't growing at 100,000. They are growing less than that.

[s]

Chinese market is in a maasive bubble so liklihood is a nasdaq like event. There is no have your cake and eat it too in this scenario. The United states consumer got the best of this trade near term. If the paradigm reverts to a china consumption model, it means the US consumer and Standard of living goes into reverse and accelerates fast. Why?

They have more poeple to thorow into the manufacturing pit even with rising wages and input costs.

Inflation becomes structural

Wages are in a structural downtrend (broadly)

Any way you cut it this is not good for US

S

[calmo]

gc identifies another element of why the Fed is reluctant to drop prime rates again: the 50bp cut provoked a decrease in the FDI position as private foreign investors exited.
The amounts of the auction tbills increased significantly to meet that shortfall, yes?
The CBs did not have an impressive share of those auctions, yes?
Long rates have not budged that much yet, but it's hard to imagine that they won't...sending those mortgage rates up, not down as the Fed intends with this "loosening".

[gab]

"...global central bankers are already facing trying to stem the rise in their currencies..."

Why are central bankers trying to stem the rise?

[jm]

Because the Fed cannot exactly predict the results of its actions, it is doomed to execute what is mainly a PID feedback control algorithm. In systems with long lags and dead times, it can be nearly impossible to control the system well using a PID algorithm; the only way to avoid violent oscillation with a period dictated by the feedback loop delay is to tune the gain coefficients so low that the response is heavily damped.

Imagine trying to take a shower under a hose running a hundred feet from a mixing faucet controlled by someone to whom you're yelling, "Hotter!", "Hotter!", "No, colder!", "No, no, no, COLDER!!!!". the only way it will work is for the person at the faucet to make very small adjustments and wait until each adjustment's effect has settled out. As long as the person at the faucet has no way to accurately predict the effect before the water reaches you, the dead time through the hose will rule, and it will be not only futile but also dangerous to be more aggressive.

Alas, much of the deregulation and innovation that has taken place in recent years has had the insidious effect of raising system gain coefficients and creating additional feedback paths with long dead times (e.g., the recent mortgage securitization fiasco).

Nearly everyone seems to believe that the Fed can keep the system on an even keel by prompt action in response to external disturbances, but in process control one quickly learns that, if the feedback loops have long lags and dead times, a control system with PID algorithm tuned to react quickly with large changes in its outputs to the final control elements (valves, etc) will blow up the plant.

[calmo]

I take it, jm you are not a systems engineer but a recreational tinkler like the rest of us (Ok, cept for you engineers out there who are just waiting for a system stall/shutdown to identify the PID components and corrections that will fix everything).
Hosing around
I think the analogy of this transfer function might be more useful if those P, D, and I blocks can be identified with the relevant housing entities (the legislation, the various players and the limits of the consumers to make mortgage applications).
The positive feedback loop that guarantees instability arose when the lenders assured clients that they need not worry about being able to afford the payments as the house itself would provide that income. And for awhile it did. Did the lenders not even know this much about control theory...or did they think that house price increases would continue forever? Like their superiors they emulated, they saw the short term self interest picture and grabbed as much as they could for as long as they could.

[jm]

calmo,

Back in the '70s I dealt in computer systems that implemented PID algorithms and the other functional blocks one needs to create large control systems. Later I spent seven years as a professional translator of Japanese rendering into English a variety of very technical documents relating to process control algorithms and systems. Though I've never tuned a PID loop in the field, I'm not just a "tinkler" (except if I shower under *really* cold water).

[anne]

Nice analysis as usual, but:

"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."

Why when employment growth averaged 235,000 a month through the Clinton Presidency with no significant inflation, should 100,000 be suddenly acceptable?

[athreya]

anne says...
Why when employment growth averaged 235,000 a month through the Clinton Presidency with no significant inflation, should 100,000 be suddenly acceptable?

Something to do with slowing down of productivity growth? Coupled with adverse demographic changes, this leads to a lower potential growth. Ergo, the non-inflationary rate of growth of the economy as well as jobs has shifted down.

[knzn]

"Something to do with slowing down of productivity growth?"

Slowing productivity growth shouldn't reduce the rate of job growth, just the rate of output growth.

People who argue that 100,000 is appropriate seem to base the argument on changing demographics (more people moving into age ranges with lower labor force participation; saturation of female labor force participation; etc.), but you have to really stretch the demographics (and ignore contrary demographic trends, such as increases in labor force participation by older people) to get a 100,000 jobs per month as an equilibrium. It seems obvious to me that much of the observed decline in labor force growth is an endogenous response to a weak job market. Unlike just about every other business cycle, this one never went through a period of strong hiring demand. The net job growth mostly took the form of a reduction in layoffs rather than an increase in the rate of new job creation.

[dd]

The virtual economy is more important than the real economy as perception (for now) trumps reality. The Fed will cut another 50bp.

[athreya]

knzn says...

"Slowing productivity growth shouldn't reduce the rate of job growth, just the rate of output growth."

And pace of job growth is independent of rate of output growth? That will be economics redefined.

My earlier comment was in response to a specific query comparing the 90s and the current decade with regard to non-inflationary job growth.

[anon.fedwatch]

I can't tell what Duy thinks from this post, which is full of hedging and dithering. His last forecast was for no cut.

The Fed will cut 25 bp because it is the second step in a two step preemptive rate cut. This leaves the option open to continue 25 bp cuts as, if and when necessary. They won't cut 50 bp because it front loads too much from a starting point of 5.25 % and sends out a signal of too much momentum. They need more room to move down from here if necessary, given the risk of low probability high consequence credit event(s) that put deflation risk back on the front burner; they can't be in a position of having front loaded too much easing in that scenario. And they won't stay put because of the real economy risk of ARM rerepricing in the pipeline - following recent early warning financial risk.