Fed Watch: Just Six Weeks to the Next FOMC Meeting!

Tim Duy is thinking about the Fed's next move:

Just Six Weeks to the Next FOMC Meeting!, by Tim Duy: Thank goodness that is over; I hope my heartburn finally eases.  I appreciate the comments, and the good natured ribbing.  I particularly enjoyed Ken Houghton's posts at Marginal Utility – “Tim Duy will be wrong, but correct” and “I Hate Being Right on this one, Tim.” Please think of me Ken as you boost your consumption spending on the back of that lower HELOC rate.

Of course, I was not surprised at all that the Fed cut rates today. When you take a contrarian view, you need to be prepared to accept the consequences. While I think the Fed was reluctant to cut rates, feeling pulled into it by market participants, the majority believed that it was the least risky strategy, especially given that virtually not a single position on the Street was prepared for anything but a rate cut. Still, if I had to be wrong on a call, I am glad I choose to be wrong on the “no cut” side of 25bp, because it was clear from the statement that that is where the action was during the FOMC meeting.

On that statement, I did get my wish, sort of. Last time out I complained that the Fed needs to stop repeating their forecast for moderate growth near potential if they are going to continue to cut rates.  The statement now begins with a focus on near term weakness:

Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance.  However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction.

Still, this is little comfort to me, as the Fed retains a benign medium term outlook:

Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

As many noted, the new reference to the September rate cut implies that this time they are serious, they are not anticipating additional easing. Alone, I do not find this to be a particularly credible indication of policy intentions, but they follow up with a clear shift to a neutral bias:

The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth.

All in all, these two parts appear to suggest that they intend to make the decision on the next rate move rather than leave it to market participants. Can they do it?

Interestingly, despite cutting interest rates, they actually heighten their inflation warnings. In September, the view was:

Readings on core inflation have improved modestly this year.  However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

Yesterday, they suddenly cared that commodity prices were surging:

Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation.  In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

Note the “among other factors” portion. What exactly are these “other factors?”  Does anyone else find it unusual, odd almost, that Fed Chairman Ben Bernanke claims to be striving for increased transparency, yet leaves us with a vague reference to “other factors”?

I can offer some suggestions. First, one might point to the falling (plummeting) Dollar. I doubt everyone at the Fed is completely confident that the pass-through to inflation will be limited, but the Fed really cannot complain publicly about the Dollar. After all, they are accelerating the fall by being completely out of step with every other central bank on the planet. Second, one might suggest rising labor costs via tight labor markets, but this doesn’t make since if they really fear near term weakness in economic activity.

Feel free to offer your own suggestions about these “other factors.” Hopefully the minutes will shed some light.

Altogether, the statement appears to offer something to everyone on the FOMC to get a consensus – an inflation warning for the hawks, a growth warning for the doves, and a benign medium term outlook for the moderates.  Note that if you combine the inflation and growth warnings, you get stagflation.

But apparently, not everyone on the FOMC got something; Kansas City Fed President Thomas Hoenig saw nothing in it for him and offered up his dissent instead. His dissent confirms that the debate centered on the 0 or 25bp side of the equation – and if one person dissents, others are likely sympathetic.

Bottom Line:  How does one handicap the December meeting based upon this statement? The Fed is telling us to follow the data, no cuts are guaranteed. Trouble is, does anyone expect this quarter to look good? To be sure, the underlying rate of growth is not the 3.9% rate reported for the third quarter – there will be payback in Q4, if on the import price issue alone. And I expect housing will be washing out in the months ahead. Will the Fed be willing to look through that weakness?  The statement suggests that they know that the near term will be weak, especially housing, and they expect us to come out the other side by mid-2008 based on current policy. In other words, they want to look through the weakness (of course, I thought that this time). They will turn their attention to employment and business investment to determine if their forecast remains on tract. If these hold, the odds are for the Fed to be sit tight in December. If these deteriorate, expect a cut – this is not the Fed’s baseline scenario.

Comments

[wjd123]

...the majority believed that it was the least risky strategy, especially given that virtually not a single position on the Street was prepared for anything but a rate cut.--Tim Duy

Why should this be a consideration?

[bullbust]

The more the Fed does this, the more it loses its credibility, and the better it would be. The inflation genie is out if the bottle, and the earlier the people understand this and dump the dollar, the less they lose.

[esb]

Yes, a strange, muddled message in the statement, understandable only as botched attempt to produce a false collective perception of the BOG's intentions.

What many in the investment community and the investment banking community have concluded is that the Fed (in cooperation with the Treasury and BLS) have elected to create significant levels of inflation while attempting (unsuccessfully) to produce a collective perception of lower levels of inflation. This, I believe, is an extraordinarily dangerous policy since it will seem to work in the beginning but then require ever-increasing spreads between the actual inflation rates and the perceived rates, leading to greater and greater levels of governmental mendacity.

It is this "pairing" that is the essence of this "con." Frankly, these are not leaders who are acting in good faith or honestly serving the citizens (individual and corporate) of the USA. They are acting to serve and protect the interests of a few.

Why these leaders believe that this is the best that they can do and the best that they can be?

Where is the integrity that used to show ... where is the respect that they earned ... where is the honesty we used to know ... where did the honesty go?

[anon.fedwatch]

It is impossible to find an FMOC post meeting statement that is not 'risk management' oriented.

[cm]

Only just today "market" "performance" indicates the next cut is in order or else.

[Don]

Oil approaching a $100 per barrel, gold at near $800 per ounce, dollar at 1970 -ish lows against other currencies--what does this all say?

If the fed doesn't reverse course, and rather quickly, we are doomed to repeat the 70's, although, it seems we are always doomed to repeat history and not learn from it. I don't think the fed, as was pointed out, could have not lowered rates, given it is a political animal with vast reach but very little capacity to act outside very narrow parameters of public opinion.

However, we should by now conclusively know that there is no trade-off between growth and inflation, (all of the period from about 1983 to 2003 comes to mind, as growth puttered along while inflation rates more or less steadily declined). Or that a strong dollar is bad for the American economy (See also, '83-'03). It appears we've already forgotten.

The trick for the fed is to supply the system with enough, but not too many, dollars. Right now, oil, gold and foreign currency are all screaming TOO MANY DOLLARS!

"Inflation is everywhere and always a monetary phenomenon."

Milton Friedman

That's all you really need to know.

[dryfly]

The trick for the fed is to supply the system with enough, but not too many, dollars. Right now, oil, gold and foreign currency are all screaming TOO MANY DOLLARS!

I agree. That does appear to be the consensus here and abroad.

[dd]

The Fed will continue cutting until the banking sector unwinds its losses.

[jan perlwitz]

Don wrote:
"The trick for the fed is to supply the system with enough, but not too many, dollars. Right now, oil, gold and foreign currency are all screaming TOO MANY DOLLARS!"

If they all are doing it where do these dollars come from? The Fed hasn't printed any significant amounts in recent months.

[Don]

Jan,

The extra dollars come from one of two places. The first is lower interest rates, which the fed accomplishes by its open market operations, buying loans until the fed funds rate reaches its target--the money they use to buy these loans is effectively printing dollars.

The other piece of the puzzle is the velocity of the money that's already in existence. If velocity decreases, i.e., money doesn't change hands as frequently as it did before, then less of it is required for a given set of outputs. Some of this sort of thing was certainly happening in the August credit market turmoil.

In any case, the best indicator of whether there is too much or too little money being supplied is to look at commodities, particularly gold, but also oil and others, and to look at the foreign exchange rates vs. the dollar. If commodities are increasing in dollar prices, particularly if the increase is broad and sustained, and if the dollar is losing value relative to its peers (e.g. sterling, Euro), it is a pretty safe bet there are too many dollars being supplied, no matter what the CPI might be signaling.

[jan perlwitz]

Don, you wrote:

"The extra dollars come from one of two places. The first is lower interest rates, which the fed accomplishes by its open market operations, buying loans until the fed funds rate reaches its target--the money they use to buy these loans is effectively printing dollars."

The total amount of outstanding repurchase agreements with the Fed is $41.25 billion dollars only as of today. This is only about $13bn dollars above the average over the last 300 days.
(See: http://www.gmtfo.com/RepoReader/OMOps.aspx)

I don't think you can call this printing of many dollars. This minuscule amount of outstanding loans related to Fed's open market operations can never ever explain the strong rise in commodity prices.

Actually, the Fed has withdrawn an amount of $5.75bn dollars from the system today, after a withdrawal of $1.5bn dollars yesterday, Nov 1. Thus, the first two days after they lowered the Fed funds target rate the Fed has withdrawn $7.25bn dollars from the system, instead of adding any additional currency.

"The other piece of the puzzle is the velocity of the money that's already in existence. If velocity decreases, i.e., money doesn't change hands as frequently as it did before, then less of it is required for a given set of outputs. Some of this sort of thing was certainly happening in the August credit market turmoil."

I don't get that. If the velocity of money circulation decreases won't liquidity be squeezed instead of increased, since the same dollar bill is used in fewer transactions? A decrease in money circulation as it happened in August is equivalent to unprinting of currency, isn't it?

Thus, neither the Fed's temporary open market operations, nor the decrease in money circulation can explain the increase in commodity prices or the dollar devaluation compared to other currencies. These phenomena have to be caused by something else. I think the fingers are wrongly pointed at the Fed.