Fed Watch: Thoughts Headed Into the FOMC Meeting

Tim Duy with final thoughts before the FOMC meeting today:

Thoughts Headed Into the FOMC Meeting, by Tim Duy: Events are moving so fast it is hard to keep up, so I will offer a series of quick thoughts as we gear up for the details of the FOMC meeting.

1. Market participants expect something greater than 50bp tomorrow, and based on recent Fed history, I tend to agree.  Still, I have something of a thought that the Fed may think they can get away with a smaller cut – the Wall Street Journal raised this question, and I am still not sure why the Fed chose a meager 25bp discount rate cut rather than bringing the full package to the table Sunday night.  Was that a signal that they expected to deliver only 25bp today? Almost unthinkable, but the relative stability in Monday’s US markets could lull the FOMC into think only 25bp is necessary.  This is not my baseline scenario.

2. Talk of liquidity traps abounds, with Paul Krugman here and the Wall Street Journal here. There appears to be a sense that a liquidity trap leaves policymakers essentially dead in the water. Krugman is wise enough, however, to note that only “conventional” monetary policy has limits in this situation.  An unconventional solution available – simply monetize deficit spending. In another post, Krugman estimates that a financial bailout may be as much $3 trillion. He also questions whether even a smaller, Swedish style bailout is acceptable to taxpayers. And we haven’t even gotten to spending for a health care fix, or improved infrastructure spending, or better educational system, or…you name it.  It seems like there is no shortage of spending options that could be monetized. And do it enough, sooner or later we would generate enough inflation to pull the economy out of a liquidity trap. I am not saying this is the best option; you want to start by avoiding the liquidity trap altogether. Still, it is an option – and lately I have spent some time thinking about options for worst-case scenarios. And as I noted yesterday, Fed Chairman Ben Bernanke has spent just a limit more time than the average person thinking about monetization and liquidity traps.

3. knzn takes issues with concerns about capital flight and whether or not it imposes a constraint on monetary policy. He accurately notes that the US is not facing an issue of foreign currency denominated debts; we pay off our debts in Dollars, which we produce.  And that we are not (yet) defending a particular exchange rate, nor should we, as a weaker Dollar is stimulative. Also true – although there seems to be some concern that the Dollar has dropped enough. But I think we disagree more on his first point:

Full employment. If all your real domestic resources are being used, then the withdrawal of foreign capital will mean the withdrawal of real resources, which will reduce your growth potential. This was an issue for the US in the late 90s. But today the US is not at full employment. And if you still think it is, just wait a few months.

I think of the problem differently – the US is still faced with a massive current account deficit that necessitates a steady inflow of capital.  If that capital flow suddenly ceases, or worse, reverse, the US is going to have to quickly fill a very big financial gap.  The fastest way to fill that gap is import compression, which I suspect would happen by cutting consumption via a spike in unemployment. In other words, I think capital flight would necessitate a very painful adjustment, one that I would prefer to be drawn out over time.

4. knzn also take issue with the inflation concern from capital flight, noting that such concerns are rendered null and void after the last inflation report. I have mixed feelings on this issue. On one hand, I generally take the data as given, which argues for knzn’s interpretation.  On the other hand, the next time I speak to a group of community members, I sense that I will be laughed out of the room if I try to sell a story that inflation is zero. Note that the day the CPI was released, so was the Michigan Consumer Confidence report, which reported a spike in one-year inflation expectations to 4.5% for March, up from 3.6% in February (longer term expectations continue to hover around 3%). So, while acknowledging knzn’s point, for the moment I will follow Stephen Cechetti’s lead:

My reading of the detail this month suggests that the dip in inflation is likely to be temporary.  To see why, have a look information on core goods prices (commodities excluding food and energy).  This portion of the CPI (the weight is a bit over 20 percent) fell nearly one full percentage point (a.r.) in February.  Given that we import a good fraction of the goods we consume, and that the exchange value of the dollar has fallen precipitously over the past year, it is natural to wonder where this moderation is coming from.  To get a hint, we can look at a few things. First, the six-month change in core goods prices is +0.5 percent (a.r.). Core goods prices are rising.  And second, the decline is entirely a consequence of seasonal adjustment.  The not-seasonally-adjusted core goods price series rose at a 4.2 percent annual rate for the month.  Yes, that's right, seasonal adjustment turned a 4+ percent increase into a nearly 1 percent decline.  I'm not usually one to worry about stuff like this. I simply accept the seasons adjustments as they come.  But some years ago I learned that the simple mechanical algorithms used to adjust the data work poorly during business cycle turning points.  So, in this case I'm very very suspicious. 

As always, good luck today.

Comments

[esb]

It is good, actually great, that you have become suspicious of the work product of the BLS.

As the saying goes, better late than never.

Oh, but if the data series are nothing other than fictitious, then "where are we."

Well that, my good man, is the question.

[Bruce Wilder]

I admire Tim Duy's courage and acumen.

[knzn]

"If that capital flow suddenly ceases, or worse, reverse, the US is going to have to quickly fill a very big financial gap. The fastest way to fill that gap is import compression..."

For a purely financial gap, the fastest way to fill it is to print money, and that will happen "automatically" if the Fed continues to target interest rates. There is no need for import compression unless we are worried about inflation. Moreover, I doubt whether there is an automatic mechanism that is likely to produce import compression in response to a reduced capital flow. The weaker dollar would make foreign goods less attractive, which theoretically should reduce imports, but my (possibly wrong) impression of the empirical evidence is that the repercussion effect of increased export demand usually outweighs the direct expenditure-switching effect on imports. A policy response designed to induce import compression would be possible, but, I would argue, neither likely nor a good idea.

What I see in the CPI report is that, regardless of seasonal adjustment, the 12-month core inflation rate is only 2.3%, which is exactly what it normally should be, even in the absence of the kind of energy and materials price increases that we have seen over those 12 months. Rising energy and materials prices are likely to have some impact on core inflation going forward, but it's really striking that the impact thus far is too small to be visible in the statistics. If we could calculate a core inflation rate net of energy and commodity inputs, it would presumably be significantly less than 2.3% over the past 12 months, which would put the inflation rate below target. (I'm assuming a 50 basis point difference between the CPI target and the semi-official PCE deflator target of 1.75%.)

I should note, also, that a sudden reversal of capital flows is pretty much out of the question. Most of the inflow is sovereign, and sovereigns, for good reason, do not generally make sudden moves. I'm even skeptical about some of the more gradual moves that are expected because of diversification of sovereign wealth funds. The purpose of acquiring sovereign wealth in the first place was generally to support the dollar. Diversification out of dollar-denominated assets would tend to defeat that original purpose and therefore will likely be at least partly offset by other actions that result in flows into the US.

[ddt]

Tim Duy is on the right track here. good article.

[ddt]

Falling Interest Rates Explain Rising Commodity Prices - Brad Setser's Blog
http://www.rgemonitor.com/blog/setser/250117

Guest Blogger: Jeffrey Frankel | Mar 18, 2008
If strong economic growth is not the explanation for the large increases since 2001 in prices of virtually all mineral and agricultural commodities, then what is? One wouldn’t want to try to reduce commodity markets to a single factor, nor to claim proof of any theory by a single data point. Nevertheless, the developments of the last six months provided added support for a theory I have long favored: real interest rates are an important determinant of real commodity prices.

High interest rates reduce the demand for storable commodities, or increase the supply, through a variety of channels:
- by increasing the incentive for extraction today rather than tomorrow (think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled)
- by decreasing firms’ desire to carry inventories (think of oil inventories held in tanks)
- by encouraging speculators to shift out of spot commodity contracts, and into treasury bills.

All three mechanisms work to reduce the market price of commodities, as happened when real interest rates where high in the early 1980s. A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories, and raising commodity prices, as happened in the 1970s, and again during 2001-2004. It’s the original “carry trade.”

The theoretical model can be summarized as follows. A monetary expansion temporarily lowers the real interest rate (whether via a fall in the nominal interest rate, a rise in expected inflation, or both – as now). Real commodity prices rise. How far? Until commodities are widely considered “overvalued” — so overvalued that there is an expectation of future depreciation (together with the other costs of carrying inventories: storage costs plus any risk premium) that is sufficient to offset the lower interest rate (and other advantages of holding inventories, namely the “convenience yield”). Only then do firms feel they have high enough inventories despite the low carrying cost. In the long run, the general price level adjusts to the change in the money supply. As a result, the real money supply, real interest rate, and real commodity price eventually return to where they were. The theory is the same as Rudiger Dornbusch’s famous theory of exchange rate overshooting, with the price of commodities substituted for the price of foreign exchange.

There was already some empirical evidence to support the theory: Monetary policy news and real interest rates, along with other factors, do appear to be significant determinants of real commodity prices historically (see graph below).

But the events since August 2007 provide a further data point. As economic growth has slowed sharply, both in the US and globally, the Fed has reduced interest rates, both nominal and real. Firms and investors have responded by shifting into commodities, not out. This is why commodity prices have resumed their upward march over the last six months, rather than reversing it.

[Pedant]

The Fed is singular. They aren't going to do anything. It is.

[ddt]

bam! I was going to use the apt phrase "man up" in some earlier posts, but I didn't want to offend Anne. Barry Ritholtz nails it:

Media Appearance: CNBC's Morning Call (3/18/08)
http://bigpicture.typepad.com/comments/2008/03/media-appeara-3.html

"This morning, I'll be debating about the upcoming Fed cuts on CNBC's Morning Call at 11:20am.

My arguments is quite simple: Since the Fed cut the discount rate on August 17, 2007, here is what has occurred:

- The CRB index is up 32%;

- The US $ Dollar index is down 13%;

- S&P500 is off more than 10%;

- Fed Fund Futures are now pricing in 100% chance of a 100bps cut;

- Generated high level chatter of a coordinated global, multi-national, currency intervention;

What the Fed is accomplishing by cutting rates is stimulating inflation, debasing the dollar, punishing savers, and making travel abroad exhorbitantly expensive for all but the wealthiest Americans.

I believe that the FOMC should "man up," show some backbone -- cut rates by "only" 50 bps. They might find out what's not to be at the Market's beck and call (girl). That should stabilize the greenback, and perhaps send food and energy prices lower (earning Ben the appreciation of consumers through out the country).

A little restraint would go a long way . . . "

[ddt]

Bernanke is playing with fire by lowering rates at a time like this. The dollar is shaky and there are already food riots happening. rice hit a 32 year high today. The rate cuts aren't working anyway (pushing on a string, liquidity trap, etc.) so why trash the dollar and drive up commodities?

also - for those who think the collapsing dollar is a good thing: the jobs in the rustbelt aren't going to magically pop back into existence the moment it becomes profitable on paper to export. Rusted out factories that have been closed for a decade don't reopen overnight. Families don't move back after checking the forex rates. The danger of high food prices in the near term far outweighs whatever benefit a low dollar might have in the long term (which you are going to get anyway)