Fed Watch: It Will Only Get More Interesting

Tim Duy analyzes the arguments for and against further rate cuts:

It Will Only Get More Interesting, by Tim Duy: Six months ago, I doubt anyone would have believed that the Federal Reserve would be cutting interest rates 50bp during a quarter in which GDP posted 3.9% (albeit likely overstated) and another 25bp during a month in which nonfarm payrolls gained 166k. Yet here we are…can it really be a surprise that oil is nearing $100, gold is topping $800, and it takes more than 2 bucks to buy a British pound? One has to imagine that the Fed must be feeling a little uneasy about pulling the trigger on another 25bp last Wednesday given Friday’s employment report. Still, they likely take comfort in the belief that they drew a line in the sand with the statement, declaring a balanced risk outlook.

But can they stick to that line during a scary four months? Can they look through to that period of “moderate growth” that they keep predicting? I would like to believe they are ready to stick to their guns, but recent history is not on my side.

The October employment report and the 3Q07 GDP report have really only one interpretation – no matter how much you gnash your teeth at the data, or accuse government statisticians of laziness or incompetence, they simply reveal that the US economy has remained remarkable resilient to the housing downturn. This doesn’t mean that everything is coming up roses in the economy; far from it. No reasonable person believes the 3.9% figure accurately reflects the US economic environment, just as no one (except the bears) paid much attention to the 1Q07 GDP report. What this year’s GDP reports suggest to me is that the economy is likely growing at somewhere around a 2.75% rate, give or take, and that this quarter will be weak.

Likewise, the employment report shows weakness where expected; my attention is drawn to retail hiring in particular. This remains consistent with my view that consumer spending is softening – not collapsing – on the back of the housing downturn. Still, solid employment growth in other sectors continues to support household spending. Truth be told, I was surprised that commentators were looking at initial unemployment claims as a signal of a deteriorating labor market; claims have been trending in the same 300k-350k range for over a year. I don’t see much difference in recent weeks.

Moreover, some of the weakness in consumers is being offshored to foreign producers. This minimizes the impact of the housing downturn on the domestic economy – remember that the housing bubbled spurred a consumer led recover that was very different that the investment led boom of the tech bubble. The collapse of the housing bubble will have consumer spending as its primary channel, and I think the ultimate impact of will be less severe than the collapse of tech bubble. Flattening employment of relatively low salary retail jobs is a far cry form mass layoffs of hundreds of thousands relatively high salary tech workers.

Still, this is not meant to imply that the next few months will be an easy ride. It won’t be; I anticipate that the housing market will be washing out late this year and early next year, and the GDP numbers will likely hover around 1%. Last November my simple recession probability model based on the yield curve suggested that the November 2008 probability of recession would edge over 50%:

Interestingly, Menzie Chin notes that:

[Late addition: 9:45am] Highlighting the uncertainties looking forward several quarters, e-forecasting's October real time leading indicators measure now reads 52% probability of recession in the next six months...

Now, the probability of recession stays high through February 2008 before dropping off in March. Note that this is a prediction based on the steepening of the yield curve last spring. The yield curve continued to steepen, pushing the probability of recession in June 2008 to around 7%. Now, on the back of Fed easing, the odds of recession by next fall are negligible.

In other words, the steepening of yield curve was signaling that the softness in the economy would pass by the middle of next year – well before anyone was even thinking about a Fed rate cut. As an aside, has anyone noticed that the bears were screaming to pay attention to the yield curve last year, and have now all but forgotten it?

While it is just a simple model, it is consistent with two points. The first is that it supports the Fed’s contention that downside risks are currently high, but the medium term outlook is more positive. Second, that in the near term economic weakness will place the Fed under considerable pressure to cut rates further, especially given continuing fears of a credit crunch.

Can the Fed resist that pressure to keep cutting even if they are confident that the medium term risks are really balanced? If the “risk management” faction at the Fed continues to hold power, it seems like more rates cuts are likely, especially if there is any hint of further softening in employment or investment. That is what recent history tells us.

Standing in the way of additional cuts, however, is these new-found inflation concerns that appeared in the last statement. Declining core-inflation has been cited as a justification for Fed easing based upon decreasing estimates of the neutral Fed funds rate. I would only like to suggest that the recent history of core-PCE is not all that comforting. Looking a three-month inflation trends on an annualized basis:

I detect something of an upward trend in the past four months, on the order of 50bp – perhaps it is too early to be lowering estimates of the neutral rate? Personally, I wouldn’t break out the champagne on the inflation story just yet. It appears, however, that Fed Chairman Ben Bernanke and Governor Frederick Mishkin – the power couple in the “risk management” regime – already popped the cork.

Of course, I think most of us suspect that we are also exporting inflation to the rest of the world, especially those economies that unbelievably hold onto Dollar pegs at a point when it is clearly becoming unsustainable. Most of us, that is, that do not work on Constitution Ave. The Gulf states, already experiencing inflation pressures – over 10% in the U.A.E. – cut interest rates to match the Fed and prevent additional upward pressure on their currencies. I can’t see this helping the global inflation picture (I warned that the Fed might unleash a global wave of liquidity after the first 50bp). On the other side of the world, China’s actions to raise fuel prices are expected to ripple through the economy and boost already rising inflation. For more, Barry Ritholtz provides the recent inflation run down here.

It would appear, however, that few nations are willing to break their Dollar links before China does, which suggests that the US will be able to keep exporting a portion of its inflation abroad for the foreseeable future. But with inflation poking up its head all over the globe, one has to imagine that an end game is getter closer. We can only expect international currency tensions to intensify with the Fed running a policy at odds with most of the world. How many Treasuries and other US assets will the world be able to absorb when inflation is less a threat and more a reality in much of the globe? Of course, reducing these imbalances should be a long run goal – see Brad Delong’s recent thoughts – but the acceptance of some slowing of US domestic demand has to be part of the process. The Fed is walking a narrow line; too much “risk management” liquidity and US growth is at odds with the rebalancing scenario.

Where does all this leave me? I want to believe that the Fed will actually follow a policy consistent with the stated medium term growth outlook, but I have already been slapped down once on that call. The employment report, if repeated in next month, clearly calls for a pause at the next meeting. But if the threat of a credit crunch is sustained throughout an already weak quarter, the “risk management” coalition at the Fed may push through another rate cut in December. Given the recent turmoil in the financial markets, I tend to shade my expectations toward another cut – once bitten, twice shy.

Comments

[robertdfeinman]

Not discussed, but maybe it should be, is to what extent are the Fed's actions politically inspired? It seems fairly clear that Greenspan tried to help the GOP, but I don't know if there is any continuing political bias as the Fed is now constituted.

Another thing that I'm still having problems grasping is the effect of external events on domestic monetary policy. For example, the world price of oil has an effect on the US, but the US can't do much to influence the world price. Several other commodities and currencies also impact the local economy. So I assume that the Fed takes these factors into account, but can their tools really compensate for such external forces?

Then there is the cascade effect from a weakening financial sector. Mayor Bloomberg has already notified NYC departments to expect lower tax revenues as Wall Street bonuses will be smaller at the end of the year. Declining home values will also cause a drop in local real estate tax revenues which should impact spending and public sector employment.

I don't see how fiddling with the rates by the Fed can control such factors. I know that similar things have been discussed in the past, so perhaps I'm just thick.

[RW]

While not denying that the Fed looks at political implications (as well as protecting banks and other money centers) I would guess that is not the key issue now: Rising unemployment, impending recession, a continuing credit crisis and ongoing damage in housing and bank balance sheets does not create a market or an economy that allows the Fed to sit tight. Damage to the dollar, Fed jawboning and the threat of increasing inflation notwithstanding I would not be surprised to see another cut and would also not be surprised to see it have no appreciable impact other than to (rather counter intuitively) increase long-term interest rates. JMO

[esb]

Tim, you should have said "twice bitten, once shy," since you have been bitten twice.

Those of us who were "running money" during the mid/late 1970s are well familiar with this game. None of us who were there will be bitten by the con men again. Those younger players who were not there are learning much faster than we did ... most have already learned to watch what the con men do and not to listen to what they say. Thus, the muddled statement following the October meeting was ignored and failed in its intended purpose, and gold was not held under $800.

However, what is most dangerous here is the intentional misreporting (by the BLS and others) of the rise in prices being experienced by the middle income quintile, only a part of which can be explained by the enormous disproportionate consumption of deflating high-end electronics products by the top quartile of the top income quintile.

Just in case any of you are in need of a little humor (or humour, depending on where you happen to be reading this), a friend in the UK sent me a drawing showing a chubby, bald and bearded man running down the steps of a Greekesque building on which the letters "FED" appeared. The man was holding a sheet of paper stating "GDP up nearly 4%." In the conversation bubble were his words, "Its a depression and we need lower rates."

Of course rates are going down in December.

[Tim Duy]

esb:

I often wonder if Fed officials have spent too much time studying the 1930s and not enough studying the 1970s.

[anon.fedwatch]

I didn't realize 'risk management' was a pejorative term for Fed easing. I'm not sure the Fed knows this either. Unless they were using a different model when they went to 5.25 %.

There's a risk they'll hold rates steady at the next meeting.

[anon.fedwatch]

Mishkin today:

" Overall, I think that the cumulative policy easing the FOMC put in place at its past two meetings reduced significantly the downside risks to growth so that those risks are now balanced by the upside risks to inflation. In these circumstances, I will want to carefully assess incoming data and gauge the effects of financial and other developments on economic prospects before considering further policy action. As always, my colleagues on the FOMC and I will act to foster our dual objectives of price stability and sustainable economic growth."

Well, it looks like they still consider inflation in their risk management model after all.

[Don]

Tim & ESB,

Yes, the 70's (the collapse of Bretton-Woods sorta looks like the coming collapse of the ubiquitous dollar pegs). No, the 30's (too many safeguards against any wholesale bank runs--like helicopter Ben says, just print money). But always price stability, both ways (not too much up, nor too much down), which is another way of saying pay attention to signals that aren't created by government bureaucrats (like the BLS) and are instead created by free, international markets for commodities--like the dollar market, gold market, oil market, etc...

In that regard, it seems everyone but Mishkin and Bernanke can see that the emperor dollar has no clothes. I just wish they'd both quit with this asinine notion that they have to balance growth, i.e., low rates, against inflation. It just ain't so. The seventies should have taught us that. Maintain efficiency in the price signals offered by a stable dollar at home and abroad, and growth, which naturally wants to occur, will follow, unless the government does other stupid stuff to screw it up, and then, at least, it's not the fed's fault.

[esb]

Don ...

And for those who are incapable of visualizing clearly "without slides" Barry has an interesting chart up over at bigpicture.typepad.com (at 8:15 AM this date).

Its a chart that only a "parabola lover" could love.

It sort of says it all.

[Don]

esb...thanks for the link...the graph looked like the hockey stick of price increases. (Hmmm, I wonder if dollar prices and earth's temperatures have some strange correlational behavioral attributes?)

Better leave that to the theoreticians. All I know is that it's feeling more and more like the days of bad hair and leisure suits.

[James]

Its the man spinning plates on a stage. On the left, we have the dollar and the Bond. Stage right, we have the stock market and the real economy.

Right now the Fed is running back and forth pretty hard, trying to keep all those plates spinning. Kind of hard to imagine an endgame that does not involve the North American Union and the Amero, IF they can present it as a non-negotiatable 'fait accompli.'

Beware of statists bearing easy ways out.

[Ryan Laker]

I am an Econ student at Southern Illinois University. My knowledge is surely surpassed by yours of the economy, but I ask: If the Fed has already cut rates twice and the economy is still in a downward turn, why would the Fed consider another rate cut? At some point is a recession and the preceding unemployment a realization? The Fed might be trying to lessen the woes, but at what point is more harm than good being done?