Tim Duy says "Bernanke opened the door for a 50bp cut" in his speech today:
50bp Looks Like The Right Call, by Tim Duy: It is always tough to come back from winter break, and this time is no exception. I actually took the last two weeks of December completely off, first time in forever. I was hoping – but not really expecting – that the New Year would bring happy economic news. No surprise; it didn’t. The tenor of the data has been noticeably weak in recent weeks, leading to an increasing number of recession calls for the US economy. Technical recession or not, my expectation continues to be that the next six months will be sluggish at best. My baseline expectation for policy was another 25bp rate cut at the end of this month, as the Fed would find it impossible to hold to their benign medium term forecast in such an environment. A 50bp cut was possible, but I was waiting for clear direction from the Fed that recent events had measurably changed their baseline forecast.
Fed Chairman Ben Bernanke seemed to provide just that confirmation in today’s speech, with what appears to be a remarkably clear statement. From the initial story by the Wall Street Journal’s Greg Ip:
Federal Reserve Chairman Ben Bernanke, acknowledging the growing threat from fragile financial markets and weakening employment, opened the door to "substantive" cuts in interest rates.
The "outlook for real activity in 2008 has worsened and the downside risks to growth have become more pronounced," Mr. Bernanke said in a speech. "In light of recent changes in the outlook for and the risks to growth, additional policy easing may well be necessary."
He added, "We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks."
Moreover, Bernanke’s reference to the sharp rise in the unemployment rate suggested that the latest data on the US labor market had spooked the Fed just as much as the equity markets. Indeed, it was reasonable to believe that the Fed itself made the recession call – after all, Bernanke cited the same evidence that many others believe is the nail in the coffin on for the post-2001 economic expansion.
All of this seems pretty straightforward, but there are some issues worth considering. Bernanke says that “additional policy may be necessary.” Market participants interpreted “additional” as additional to the 25bp already fully priced into the markets, assuming that Bernanke intended to entrench growing expectations of a 50bp cut. The possibility remains that the Fed’s baseline was zero, rather than 25bp. That said, I like to believe that Bernanke is not really ignorant about the impact of his speeches on expectations.
Also, Bernanke appeared to backtrack a bit during the Q&A following the speech. He seems to imply only minimal revisions to the Fed’s baseline forecast, and explicitly rules out a recession forecast for the time being. If the Fed’s forecast has only minimally changed, that would argue for a “risk management” 25bp cut rather a “recession is here” 50bp cut.
Still, my tendency is to downplay such caveats and assume that Bernanke is signaling a push for 50bp on January 31. Again, I don’t like the idea that he is completely unaware of how his speech would be interpreted, and, with the exception of the December meeting, the Fed taken the more aggressive of the likely policy choices. If Bernanke is not happy with the market reaction, he still has time to let us know.
An interesting addition to the news mix was Kansas City Fed President Thomas Hoenig’s remarks. From Bloomberg:
''The fact of the matter is inflation has been rising, while the economy has slowed,'' Hoenig said in a speech to business executives today in Kansas City. ''That's a difficult dilemma.''
''It's fair to say the U.S. economy has been under considerable stress,'' he said. ''While the economy is slowing, at least a case can be made that the economy will come out of this slow growth'' this year. He predicted an expansion of 2.5 percent.
Note that Bernanke downplayed inflation concerns, leaving it as little more than a side note, largely the standard boilerplate warning about monitoring expectations:
Even as the outlook for real activity has weakened, there have been some important developments on the inflation front. Most notably, the same increase in oil prices that may be a negative influence on growth is also lifting overall consumer prices and probably putting some upward pressure on core inflation measures as well. Last year, food prices also increased exceptionally rapidly by recent standards, further boosting overall consumer price inflation. Thus far, inflation expectations appear to have remained reasonably well anchored, and pressures on resource utilization have diminished a bit. However, any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months ahead we will be closely monitoring the inflation situation, particularly as regards inflation expectations.
By itself, something of a downer on the rate cut story, but as it was just a single paragraph at the end of the speech, it suggests that the inflation issue is not much of a dilemma at all. Moreover, the Fed’s actions don’t really suggest a dilemma; rising commodity prices, higher core inflation (see below), and a falling dollar haven’t prevented a steady stream of rate cuts since last summer.
Also, Bernanke’s claim of diminishing utilization pressures (higher unemployment) indicates that he sees current inflation as a short-lived phenomenon that will quickly yield in the face of lower growth. Did Hoenig not get the memo? For now, my working assumption is that Hoenig is out of touch with Bernanke and therefore out of touch with the Board (Yes, I become very unhappy with regional presidents who appear out of step with the Board – they detract from the stated goal of additional transparency).
Simply put, inflation just doesn’t appear to be a Federal Reserve priority at this moment. (In contrast with Greg Ip’s WSJ article from just last week. Note also that Greg Ip’s cover story this morning retains a noticeably more hawkish tone.) Should it be? Recent readings on core inflation, in my opinion, have not been particularly encouraging. Note the near-term trend in core-PCE:
That said, if the economy is headed for a recession, history suggests that core-inflation will role over in the months ahead (again, diminishing resource utilization). Betting on a Fed policy error at this juncture requires that you believe the downturn is mild and short-lived and global forces are conspiring to push up inflation via higher commodity prices and a weaker dollar regardless of the internal dynamics of the US economy. I am not entirely unsympathetic to this view – it is hard to ignore commodity price signals, with the world looking at $100 oil rather than the $10 oil of the 2001 recession, gold pushing to $900, etc. – but until inflation becomes obviously entrenched in expectation-based measures, the Fed will focus on the growth story. I imagine Arthur Burns thought likewise.
(As an interesting side note, I spent an evening this week with a group of purchasing managers, many of who were unhappy that all this news of recession was not yet helping them via lower prices.)
Bottom Line: Bernanke opened the door for a 50bp cut. Dismissing saber rattling by hawkish policymakers continues to be the winning bet.