Fed Watch: Ignore the Hawks

Tim Duy says if you hear hawks screeching, pay them no mind:

Ignore the Hawks, by Tim Duy: Ignoring hawkish Fedspeak has been the winning strategy in recent weeks as increased market turmoil pointed to another rate cut this month despite repeated warnings from Fed officials. Clear statements that economic weakness is expected in the near term are dust in the wind compared to widening credit spreads. The debate is shifting towards a 50bp cut – a cut that cannot be ruled out given growing risk aversion in financial markets.

As recently as early last week Philadelphia Fed Charles Plosser reminded investors to ignore weak data:

In my view, if the FOMC members already expected some bad economic numbers and had already taken those into account in their outlooks when they set the fed funds rate target, then you should only see policymakers take action when the outlook changes significantly – not when a few pieces of bad economic news are released.

I doubt that Plosser was happy with the October rate cut, and I suspect he was less than thrilled when Fed Governor Donald Kohn came to the podium and gave the all clear for a rate cut in two weeks:

However, the increased turbulence of recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October. Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses. Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses a well.

Kohn is quite clear – ignore Plosser. While recent data may be as expected, the downside risks are once again on the rise and threaten to disrupt our benign forecast. This point was reiterated the next day by Fed Chairman Ben Bernanke, cementing the importance of recent credit market tightening in the upcoming FOMC decision.

Amazingly, Plosser did not take the hint, saying the following day that:

''I'll reserve my judgment until I get more information'' on whether risks have shifted, Plosser told reporters in Philadelphia today. The Fed will ''watch and see and react as appropriate.''

And more amazingly:

Plosser said of Bernanke: ''You may be sure of what he thinks. I'm less sure of what he thinks.''

Plosser will be a voting member in 2008 – it should get interesting if he doesn’t spend a little more time thinking about what Bernanke thinks.  Plosser also floated the idea of cutting the discount rate, possibly to shift expectations away from a target rate cut:

Plosser noted that the Fed ''could'' further reduce the gap between the main rate and the charge on direct loans to banks. Officials in August lowered the discount rate by half a point, bringing the gap to 0.5 percentage point. The discount rate is now 5 percent, and the federal funds rate target is 4.5 percent.

''It certainly would be something that one could entertain,'' Plosser said about further reducing the spread between the rates.

To give Plosser the benefit of the doubt, these quotes may have been taken out of context, but one has to wonder if Plosser is reading any speeches other than his own given that Kohn already threw cold water on this approach:

In that regard, I think we had some success, at least for a time.  But the usefulness of the discount window as a source of liquidity has been limited in part by banks' fears that their borrowing might be mistaken for accessing emergency loans for troubled institutions. This "stigma" problem is not peculiar to the United States, and central banks, including the Federal Reserve, need to give some thought to how all their liquidity facilities can remain effective when financial markets are under stress.

No Charles, the discount rate is simply a side show at the next meeting – market participants have wisely shifted the discussion toward a bigger fish, a 50bp cut. Deterioration in credit spreads is approaching the level that prompted a 50bp cut in September. And in some ways may be even worse. As noted by Jim Hamilton, risk aversion is spreading beyond commercial paper to Baa rated corporate bonds.

Still, I suspect the Fed will be hesitant to come to the table with a 50bp cut. Even the doves think they have already frontloaded policy. And the hawks will be foaming at the mouth as they likely believed that the balanced statement of risks implied a pause in December, and actually want to see hard data that changes their outlook before cutting again. I think that it would have been easier to justify a 50bp cut in December if they had passed on Halloween, but that ship has sailed.

Also, there are likely some lingering inflation fears on the FOMC.  Note the three month trend in core-PCE:

Three-Month Annualized Percentage Change in Core PCE

While the year over year trends are comforting, the recent behavior of inflation is less so.  Of course, given Bernanke’s focus on the credit situation, a recent uptick in inflation (a lagging indicator) is not going to forestall a rate cut, but it may give some pause before a 50bp cut, especially given the recent jump in headline inflation.

Bottom Line:  The rate cutting continues, the Fed’s benign medium term outlook notwithstanding.

Comments

[calmo]

I can see the volatility of the market has spilled over into the FOMC heads ...displacing cooler heads.
Ok 25bp cut and some disappointment from the market that is hoping for more...which may cause some general disappointment (as the only flag in the economy not drooping was the market).
So the market in a sense holds the Fed hostage whose only weapon is to declare as ominously as possible that there is a growing risk of inflation...a weapon that needs constant sharpening and polishing to escape the Dangerfield plight.
50bp sends the message that "we're inforit", even if it does help the market, even if it does send the cojoinder that the market has the Fed in its pocket, even if this message depresses the consumer's sagging confidence still further...how bad would the consumer data have to be for BB to drop 50bp?
Alrighty then, 25bp.

[Winslow R.]

Where is the outrage?

Kohn makes multiple predictions (blunders) that should have anyone that has any sense of economic fairness in convulsions.

If one reads the tea leaves in the q & a long term rates are headed higher as nonbank, medium and small bank assets are repossessed by large banks.

http://www.cfr.org/publication/14890/

That 50 basis point cut in the discount rate that Kohn dismisses because:

Kohn: "we would be creating, I think, problems for the open markets, because they would have to anticipate how many reserves are going to be supplied through the discount window, which would be very hard to anticipate, and then drain those through open-market operations."

yet would level the playing field between small and large banks, horrors bank consolidation might end!

Kohn: "There are people who don't borrow at the federal funds rate, right -- smaller, medium-sized banks. And if they saw this window, they would come in and borrow -- basically, we would be giving them funds at a subsidized rate that people don't ordinarily have access at the funds rate."

Just imagine if the Primary dealers and the Bank of New York were no longer 'needed' to create liquidity and their 'subsidy' disappeared? New York would no longer be the center of the 'subsidized' financial universe.

Small and medium size banks could offer collateral (tsy secs) directly to the Fed in exchange for funds at the current fed funds rate. Could simply offer to purchase any excess at current fed funds rate making the fed fund rate not a target but a rock hard rate. What a nightmare for the Fed?

[Dickeylee]

Salient points Winslow, but the whole world MUST revolve around the NYSE and MUST lay prostate to those NY banks you speak of. Wait for when the Sauidi's demand payment in Euro's instead of Dollars, then you'll be needing a wheel barrel to carry your money to the grocery store...

[ST]

I agree with Winslow. The Fed needs to provide some serious justification for use of the federal funds rate to provide liquidity to the market (as opposed to using it to stimulate the economy overall). The discount window exists to fill this need -- and the stimulatory effect of rate policy means that the discount window should be preferred as a tool for injecting liquidity in a crisis.

If the Fed wants to provide liqudity to other financial entities in addition to banks, why doesn't it just invite them to borrow at the discount window too?