Fed Watch: Sometimes It Is the Path, Not the Destination

Tim Duy tries to figure out what the Fed and the economy will do next. All I can say is good luck:

Sometimes It Is the Path, Not the Destination, by Tim Duy: I spent much time this weekend – as is often the case – considering the path of economic activity over the next year, as well as the Fed's role in defining that path.  The Fed has come under widespread criticism for a seemingly awkward communication strategy that culminated with last week's surprise rate cut.  I think the last rate cut had the unfortunate appearance of a panicked effort to prop up equity markets.  That said, I think the criticism is likely too severe – it is easier to be bitter with the Fed than to admit you just weren't reading the situation correctly.

Of course, it is likely the Fed was not reading the situation correctly as well.  But what part of the forecast was in error?  We have heard repeatedly of Fed expectations that the economic downturn would be largely limited to the first half of 2008, followed by a gradual reacceleration to trend growth, albeit the anemic trend of roughly 2.5%.  We do not yet know that this forecast is fundamentally in error.  Indeed, I have argued in the past that it is consistent with the story told by a one-year ahead forecast derived from the yield curve, specifically the 10-2 spread:

Looking at the more recent history more closely:

The depth of the inversion of the yield curve in November 2006 signaled a 50% percent chance of recession in November 2007 – remarkably accurate, in retrospect.  But this is where the path vs. the destination becomes important.  In December of 2006, I told a business group that the then current recession hysteria would be short lived, but would return at the end of 2007.  I, however, didn't fully know the path to that point – I said it would likely reflect the washing out of the housing market.  For that particular group, I don't think the path was particularly important.  For financial markets, both the destination and the path are important.  The permabears, who were aggressively predicting a recession in early 2007, largely had the path right (financial market meltdown stemming from a faltering housing market), but were a year ahead on the timing.

The steepening of the yield curve signaled by the middle of 2007 that the risks of recession would be dropping dramatically by the middle of 2008.  Interestingly, this fit nicely with the Fed's forecast of late last year.  The Fed could see the destination – the other side of the downturn, and this was able to make statements such as that of the October 30/31 meeting:

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.

The problem, however, is again the issue of the path to the destination.  We can assume that Fed forecasts were largely based on a "constant policy" assumption.  They saw the destination, but misjudged the path – the steepening in the yield curve was signaling that the Fed had a significant role in leading the economy to that destination.  And that role was aggressive rate cutting (not academic tinkering with the discount rate), rather than holding policy constant.  The Fed was trying to focus market participants on the medium term outlook, market participants were telling the Fed they need to do something more to ensure that outcome.  Needless to say, confusion reigned.

Is the Fed's forecast still viable?  I think so.  The yield curve is a good predictor of economic activity – note how the permabears no longer discuss the yield curve; it no longer fits in their paradigm. But I see the path unfolding over the first half of this year.  The aggressive rate cutting by the Fed is forcing central banks around the world to continue and even accelerate their purchases of dollar denominated assets, especially those that limit or prevent the appreciation of their currencies.  This supports a capital inflow to the US to offset the collapse in the asset backed commercial paper markets and keeping the US financial markets more liquid than they would be otherwise (Brad Setser continues to repeatedly educate us on this topic.  See here and here.) The general tendency toward lower rates across the yield curve tends to have a stimulative effect – eventually, mortgage rates drop low enough to help some homeowners.  Not all of us are underwater, and could benefit from refinancing. 

The US government further supports this process with a temporary stimulus package, issuing debt that foreign central banks are forced to buy, turning the proceeds over to consumers, many of whom are sure to boost spending.  Those economies that choose to hold monetary policy constant, such as the European Central Bank, support the US economy by allowing their currencies to appreciate against the dollar, internalizing the US weakness. 

All of these stimulating forces are coming to bear over the next six months.  But will they be lasting effects?  It depends on what you define as "lasting."  This story is one in which strong economic growth in the US depends critically on a sustained capital inflow.  Capital inflows supported the tech bubble.  When that story ended, a few years of subpar growth occurred until capital inflows could find a fresh asset bubble, housing.  Where will the next bubble be?  Will it even be in the US?  Without that consistent, and growing inflow, I suspect the US will suffer a protracted period of subpar activity as the economy is weaned from reliance on foreign production.  Or a steady stream of "temporary" stimulus packages forced upon global central banks for financing, until the world is finally saturated in dollar denominated assets.  Or a steady stream of monetary easing?  Or…?  This is something I am still thinking about.

Bottom Line:  The amount of stimulus, largely monetary, but also fiscal, coming on line in the next six months suggests that the worst part of the downturn will be relatively short lived, limited to the first half of this year.  But the other side of the downturn is likely to be anemic, similar to the wake of the 2001 recession.  Lasting growth of the kind we are accustomed to, I fear, depends on capital inflows to support a fresh US asset bubble.

Postscript:  Obviously there is a Fed meeting this week.  Market participants are expecting 25 or 50bp, most likely the latter.  I see that as the most likely result, especially since it is clear that the Fed deems the health of the equity markets as critical (note, this fits into the above story, as a weaker dollar will entice foreign capital into the equity markets - the foreign currency price is lower - as long as equities are not set for a precipitous drop).  But, every call is something of a toss-up right now.

Post-postscript:  I just realized that if I follow the argument through, my opening statement about the Fed's cut last week merely having the appearance of an effort to prop up equity markets is overly charitable.  Perhaps it was simply a straight forward effort to prop up the equity markets to keep foreign players in the game.

Another postscript:  It occurs to me that the US is doing the opposite of everything it advised in the Asian Financial Crisis. 

Am I currently placing too much weight on the importance of capital inflows?  Feel free to comment.

[Tim starts with "I spent much time this weekend ... considering the path of economic activity..." Here's something else Tim did this weekend. This is what happens to Fed watchers when economic conditions get like they are now. Tim is on the left.]

Comments

[Bubbles and Foreign Savers]

"Where will the next bubble be?"

Many people drew the conclusion that over concentration was the reason they lost money in equities when the tech bubble burst. They strove to diversify widely across all equity classes, which drove asset prices up across the board. For example, in Y2K you could buy a REIT index fund (yield over 9%), or small cap value fund quite inexpensively. Now they are both pricey by historical standards, right along with the S&P.

Foreign savers may similarly draw the conclusion that greater diversification in real estate is prudent. Rather than helping Californians to further bid up the high 6 figure price of dilapidated 2 bedroom cottages, they may choose to buy mortgages in less heavily zoned areas across the globe.

"Will it even be in the US?"

To a degree, the bubbles are already world wide. Housing prices are elevated in many parts of the globe. Emerging market equities have been going up at a rapid pace. Baskets of commodities have become a standard asset class for many portfolios. I would think the US will continue to receive foreign savings, but foreign savers will likely seek greater diversification world wide.

"Am I currently placing too much weight on the importance of capital inflows?"

I don't think so. The US has such a low savings rate that we are completely dependent upon foreign savers to fund business expansion, and even home mortgages. If foreign savers decide that their money is not save here, that will be a big jolt.

Especially with the baby boomers nearing old age. As people age, they tend to spend less. They also tend to want to sell their 401k equities, and there is not enough domestic demand to keep their valuations at current levels. If foreign savers don't buy them, retirees may not have much to spend. A downward spiral.

[kharris]

I generally like Duy's work. I generally shy away from analysis that contains a heavy dose of straw men. Duy needs to tell us who he means by "permabears" or drop it. That is a term of derision used by those who profit from stock market transactions. I realize that Steven Roach might fall into that category, but I frankly can't think of anybody else.

Duy may well prove correct about the duration of the downturn, but he ain't right yet. There is a little too much before-the-fact triumphalism in implying that the other side is wrong before the facts are in.

[kharris]

Oops,

Stephen Roach.

[donna]

We can't live on bubbles forever. When the heck are we really going to change the direction of this country? This financial manipulation is all fun for the financiers, but those of us who actually want to make things are getting very bored. Bored, bored, bored....

[Bubbles and Leveraged Credit]

Lots of shaky real estate, municipal, and corporate loans out there. The leverage involved in the unregulated $45 trillion credit default swap market magnifies this risk. The credit default swaps cancel each other out in a complex relationship (theoretically eliminating risk), but only if all counter parties live up to their obligations.

If the basic loans on which this leverage pyramid are founded prove to be unsound (e.g., sub prime, insured muni bonds losing their insurance due to insurer failure), the entire CDS market is put at risk. Again, the fantastic leverage magnifies risk to the system many fold.

[james]

"Am I currently placing too much weight on the importance of capital inflows?"

I think so. Net capital inflows are determined and limited by the current account deficit and the dollars that are exported by it. Its a bit far fetched to conclude that dollar weakness outside of the dollar peg zone will cause pegging central banks to buy more dollars. Setser believes that capital flows determine current account deficits - that's the wrong causality.

[lonesome moderate]

Excellent article, thanks as always to Mark for finding the one best article (out of seemingly hundreds available in Cyberspace) and bringing it to our attention.

When I hear the word "Permabear", the first name that comes to my mind is Nouriel Roubini.

To me, before you can answer the question "how deep and how long will the recession be?", you have to ask "how much farther are housing prices going to drop?" People like Roubini and Paul Krugman seem to think that they will inevitably drop until the price/rent ratios are near historic norms, i.e. another 10% or 20%. That, to me, implies a nasty downturn, probably followed by years of near-zero growth similar to Japan in the nineties. But does this have to be true? I don't see anything magic about the price/rent ration that would always force it back to historic norms.

[Supply and Demand]

LM..."how much farther are housing prices going to drop?"

People won't buy what they can't afford, at least in the long term. On most supply/demand curves, higher prices lead to lower demand. After a certain price point is reached, most people decide that the product just isn't worth it. They look for alternatives (renting, more people living in a home, moving to lower cost areas, etc...). Policy (e.g., mortgage tax deduction, FHA guarantees, low interest rates, restricting supply) can alter the supply/demand curve, but not permanently repeal it.

LM..."Japan in the nineties..."

Japan's baby boom is older than ours, and xenophobic Japanese culture doesn't like foreign immigrants. When its boom passed its prime, there were fewer left in their prime years to produce/spend. The smaller demand could not support the fantastic prices real estate had reached (Japanese were taking out hundred year loans that their great grandchildren were supposed to pay off). Japan just didn't have enough workers left to produce enough product to bid the prices higher with. Taking resources away from workers to build bridges to nowhere just left workers even fewer resources to buy consumer products with. Since their great grandchildren were not able to pay off the home loans their great grand parents had taken out, banks had too many bad loans on their books. Banks couldn't lend any more out because of mass default on the old loans.

Our baby boom was post WWII, when the soldiers came home. Theirs was prior to WWII, when they were encouraged to have lots of babies to rule their rapidly expanding empire. After the tide of war turned against them, they stopped having babies. They peaked earlier than we did. Since we allow many more immigrants, the aging of our baby boom is not likely to have the same magnitude of effect.

[tim146]

Why do we = the USA and Canada - reward the mediocre?