Fed Watch: A Newly Hawkish Fed

How will the Fed respond to recent information about inflation expectations and the state of the economy?:

A Newly Hawkish Fed, by Tim Duy: The Fed’s shift to a more hawkish stance in recent weeks has put an end to expectations of additional easing, shifting the debate to the timing of the inevitable rate hike. Nearly unrelenting questioning of the Fed’s commitment to price stability appears to be weighing on policy makers, even arch dove San Francisco President Janet Yellen:

The Federal Reserve cannot, however, be complacent about inflation. Some survey measures of long-run inflation expectations have inched up, and measures of inflation compensation derived from the differential between nominal and real Treasury yields are slightly higher, too. While none of these measures are perfect indicators of inflation expectations, recent movements highlight the risk that our attempts to deal with problems in the real economy could lead to higher inflation expectations and an erosion of our credibility.

While Yellen retains a benign inflation outlook, she recognizes that inflation expectations are shifting in a disconcerting direction. Paul Krugman believes it would be a mistake to listen to such inflation concerns:

In short, this doesn’t look at all like the 70s. Inflation is nasty, but it’s not getting a grip in a way that will cause it to persist if and when oil and food top out. And it would be a big mistake if the Fed lets fear of inflation distract it from the urgent task of heading off a financial meltdown.

The Fed, I suspect, will not entirely embrace Krugman’s position. The Fed is seeing the end of the tunnel with respect to the financial crisis (others, of course, see only the eye of the hurricane). And note the Fed will be wary of repeating their mistake in 1999 of failing to quickly reverse the emergency rate cuts of the previous fall. The TED spread fell to 80bp last week, well below the highs of over 200bp experienced during the height of the crisis. True, this could simply be a head fake; previous declines in the TED spread, such as that in February, proved to be short lived. Still, tolerance to risk appears to be returning to financial markets in general, and the 2-year Treasury has climbed to 2.65% while the 10-year broke the 4% mark last week – a signal that market participants are ready to accept a policy shift.

The Fed also views inflation expectations as uncomfortably fragile at this point. From the Cleveland Federal Reserve Bank:

Note that the Cleveland Fed’s measure of inflation expectations has recently deviated from the low expectations posited by professional forecasters to the higher expectations of consumers. It may be that economists are failing to see a fundamental turning point in the inflation outlook (shocking, I know). Dow Chemical’s decision to raise prices by as much as 20% will also be seen as a possible turning point in the inflation story as it signals limitations in trying to absorb steeply higher raw materials costs via lower margins or higher productivity. The Fed will be watching for signs that other producers are following suit.

Widespread price increases, however, would need to trigger corresponding wage increases to definitively lock in higher inflation expectations. On this front, the sluggish job market is clearly in the Fed’s favor. Undoubtedly, unions will be pressing for compensating wage increases wherever possible, and some, perhaps many, will succeed. Nurses, for example, will have an upper hand in negotiations due to chronic labor shortages. Autoworkers, in contrast, will face more of an uphill battle. But considering the low levels of unionization in the US, it is tough to see even the successful wage campaigns to be sufficient to trigger an inflationary spiral.

So, while rising inflation expectations will keep the Fed on hold and pondering the timing of a policy reversal, they will not rush into a rate increase. True, Dallas Fed President Richard Fischer talks tough:

I am also not going to engage in a discussion of present monetary policy tonight, except to say that if inflationary developments and, more important, inflation expectations, continue to worsen, I would expect a change of course in monetary policy to occur sooner rather than later, even in the face of an anemic economic scenario. Inflation is the most insidious enemy of capitalism. No central banker can countenance it, not least the men and women of the Federal Reserve.

This may be in fact the appropriate policy, but it is easier said than done in a weak economic environment. Little of the incoming data warms my heart, and remains consistent with an economy in or very near recession. (I tend to think the distinction is essentially meaningless at this point.) And I take little comfort in the upward revision of the 1Q GDP release. My eyes are drawn to the decline in final sales to domestic purchasers, the first such negative read since 1991. Also, Menzie Chen notes that per capita GDP growth has fallen into negative territory. Even though the pie is growing, the individual pieces are shrinking.

Abysmal readings on consumer confidence reflect those shrinking pie pieces, although the May decline appears excessive in some respects. Still, the high inflation expectations of 5.2% over the next year is weighing on consumers, and if expectations are indeed correct, we could see real consumption post a negative number for 2008 as a whole; the last such occurrence was in 1980. So perhaps the confidence numbers are not so anomalous. The weak labor market is also weighing on consumers, and that weakness is likely to be confirmed in the upcoming employment report. The elevated level of jobless claims still falls short of that consistent with recession, but the steady rise in continuing claims suggests a rising unemployment rate nonetheless.

The advance durable goods report offered the rare bright spot last week, with the non-defense, non-aircraft component up a sharp increase, continuing to run contrary to the recession story. Export strength is likely supporting new orders, and thus manufacturing activity remains stronger than would otherwise be expected. In my opinion, the combination of import compression (which off-shores internal consumer weakness) and export compression explains what is a relatively mild decline in nonfarm payrolls compared to the significant domestic slowdown. And while there is a persistent fear that US export growth will collapse in the face of a global economic slowdown, note that the Baltic Dry Index recently surpassed the highs reach last fall, indicating a reinvigoration of global growth. This suggests that, for the time being, the external sector will likely continue to support the US economy somewhere near a sweet spot for the Fed, with enough strength to justify holding rates steady, but enough weakness to avoid raising rates even as inflation expectations climb.

Short Version: With some indications that the worst of the financial crisis is over, and rising inflation expectations becoming increasingly uncomfortable for policymakers, the Fed will hold policy constant through the summer. Rising bond yields – and the implication that fixed income traders will acquiesce to shift to stable policy – will provide comfort to policymakers. Barring clear evidence that inflation expectations are triggering widespread wage growth, the damaged economy will delay any rate hike until this fall at the earliest.

Comments

[Barkley Rosser]

That decline in the TED spread could easily be a head fake, especially given the continuing slide in housing prices (this will not be really over until they stop falling), but if it is not a head fake and the Fed has managed to get ahead of this with all its unusual policy responses, that will make our guy Taleb look a bit silly, although if his company is selling a bunch of wild puts to suckers expecting some really monstrous further crash, he will not mind.

[Relative Price Changes]

"...the continuing slide in housing prices..."

Relative prices need to rise/fall to allocate capital efficiently. Relative price changes are not a crises, just normal operations for capitalism.

[outsider]

G.M. offers buyouts to lay off people, my work leaves vacancies whenever anyone retires rather than a new hire, we're 9 trillion in debt, it's an election year, unions are begging, tax rebates are the fashion, all the Presidential candidates are for more tax cuts and snarling at Iran, Oh Hell yes, let's raise interest rates.

I'm in foreign bonds.

[IdahoSpud]

Yellen: "...could lead to higher inflation expectations and an erosion of our credibility."

Their credibility vis-a-vis inflation is pretty well shot, IMHO. The massive and repeated knee-jerk reductions in overnight rates and new lending facilities are thinly disguised efforts to save feckless bankers from themselves.

There isn't a hint of concern about inflation in any of these moves.

If 5.5% FF rate was considered necessary to contain inflation prior to the shadow banking system collapse, wouldn't 5.5% be appropriate to contain inflation right now? Inflation rates and expectations are bearing this out.

Other than the need for (shadow) banks to recapitalize on interest spreads due to their own poor lending practices, is 2.5% really where we should be right now? The Fed is being overly accomodative to the financial and equity markets. Are those markets really so delicate?

[Rajesh Raut]

The rise of inflation is part and parcel of the financial crisis. We have seen a flight to safe financial assets in response to uncertainty about credit quality. Other money has left financial assets and flowed into "hard" assets: gold, oil, and other commodities amplifying the global demand/supply imbalance. This inflation is not caused by rising capacity utilization so a weak economy will not undermine the rise in prices. Raising interest rates while pumping liquidity into the financial system using the TAF facility will only worsen the housing crisis; bail out the financial speculators that caused the problem and have little impact on overall inflation.

[Barkley Rosser]

Relative Price Changes,

Oh goody, another commenter with a moniker that is a slogan for a speech.

Guess you have not been paying attention have you? Sure, housing prices got too high in many parts of the country and need to come down. But, that is the problem. There was something called a speculative bubble in housing. Or are you one of these fantasists who do not believe that there are such things as speculative bubbles? Historically the collapse of really large speculative bubbles have sometimes led to pressures on the entire financial system that cause problems with the macroeconomy, and that is what we have had here, especially given the peculiarities of the financing here with all these bad subprime mortgages that went bad.

So, I am not saying the Fed should prop up the housing prices. I am simply noting the hard reality that what makes those subprime (and other) mortgages go bad, thereby making all those derivatives based on them that got scattered all across the globe, is declining housing prices. So, as long as housing prices keep falling (and there is reason to believe they might continue to do so for some time to come), then we continue to be in danger of having banks fail and other unpleasant events that have broader negative indications for the economy as a whole. This is macroeconomics, not just the microeconomics that "relative prices" are about.

[Goldilocksisableachblonde]

Is it possible that the Fed's concern is not with inflation expectations but with current inflation , which they know to be much higher than reported figures ? They must be 'in the loop ' of those who know the extent of data-massaging that is occuring.

Even the Dow Chemical CEO , among many , thinks reported inflation is understated : http://www.cnbc.com/id/24888493

BTW , pardon the moniker , but it's not my fault -- I was born with it. My mom had a wicked sense of humor.

[Barkley Rosser]

As the obnoxious sourpuss whining about monikers, I think yours is most amusing, "Goldi..." It is these folks whose monikers suggests that they know more than others or are somehow superior to others, which they then manage to disprove quickly when they post, that I find annoying. Of course, given how stupid some of their posts are, perhaps I should not blame them for seeking to conceal their actual identities...

[donna]

Barkley, you're assuming they know what their actual identity even is. ;^)

[Great Anonymous Superior Intellect the Wise]

Barkley..."It is these folks whose monikers suggests that they know more than others..."

How dare they. :)

Barkley..."Historically the collapse of really large speculative bubbles have sometimes led to pressures on the entire financial system..."

Only when excessive leverage was involved. Too much leverage puts the system at risk, not relative price changes. Price changes can be magnified by high leverage, and interference with the free market. Relatively free Texas does not have the problem that over zoned CA does.

[a]

"...It is these folks whose monikers suggests that they know more than others or are somehow superior to others..."

Why are economists so worried about someone else feeling intellectually superior? Does all of life have to become a question of whose intellectual dick is biggest?

[Barkley Rosser]

Great Anonymous (sounding like a renamed RPC),

The issue of Texas versus other parts of the country is not leverage but land use restrictions on building homes, more to the point, the lack of same in TX, which I am perfectly willing to accept held back the bubble in TX.

OTOH, we have the spectacle of 1986. Were you around then, oh great expert? There was lots of commercial real estate speculation in good old Texas during the early 1980s, partly fueled by leverage, but mightily so by tax breaks (leading to the famous "see-through" office buildings of Houston), and high oil prices.

So, then in mid-1986 the Saudis got tired of propping up the price as Iran and Iraq cheated on their quotas to buy arms to fight with each other and turned on the spigot. Price of oil fell rather quickly from about $34/barrel to about $9/barrel, and suddenly lots of commercial real estate owners in TX were going under water. This was the epicenter of the great Savings and Loan crisis, which eventually cost US taxpayers about $100 billion (and then VP G.H.W. Bush high-tailed it to Riyadh to beg them to save his pals, which the Saudis did partly by putting the price back up into the teens, but not good enough to bail out the Texans, much less the US Savings and Loan industry).

Certainly bubbles are further aggravated by "excess leverage," but how does one know that it is "excess"? Do you only claim it "must have been so" after the fact when you see a bubble crash?

"a" Well, clearly you should be "a+" compared to all the "a-"s and "b"s and "c"s posting comments here...

As for the more usual issue on monikers, I understand that some people have jobs where their bosses might not like what they post. I also realize that many consider it chic to have cool monikers. Personally, I am old fashioned and do am not impressed with this, although I accept the first argument. But, if you do not have a boss looking over your shoulder, what do you have against using your own name?

[Great Anonymous Recycled Moniker]

"...partly fueled by leverage, but mightily so by tax breaks..."

Yeah, those were silly. RR got rid of them.

"Certainly bubbles are further aggravated by "excess leverage," but how does one know that it is "excess"?"

Partly this must be determined by trial and error with respect to each sector. Stock margin was reduced from 90% in 1929 to 50% when it became obvious 90% was too dangerous to the system. It has now become obvious that 0% down NINJA mortgages are too risky to the system. Something less than that, maybe 20% down. Taxpayers will be on the hook for GSE guarantees, which are now virtually required to market securitized baskets of new mortgages.

In general though, prolonged negative real interest rates are just asking for trouble.

[Barkley Rosser]

Recycled,

Just to give full credit where it is due, the tax simplification of 1986, initially suggested to RR by George Schultz, went 180 degrees against his tax cuts of 1981 in many ways (those were a regular Christmas tree of special interest breaks, especially for commercial real estate), and were supported by many Dems in the Congress, with in fact two Dems being the first two support drastic simplification, in the form of Bradley-Gephardt.

Now, I happen to consider it unfortunate that the Dems, including both Bradley and Gephardt, both of whom would later run for president (Gephardt twice), forgot the virtues of tax simplification and forgot about it.

Likewise, I happen to consider it unfortunate that Bush passed up the chance to do another cleaning of the tax code whorehouse in his second term the way RR did. This could have gotten bipartisan support as RR did, if done properly. Instead Bush wasted his political capital on his assinine attempt to privatize social security. Of course, this had been an obsession of his since he first ran for Congress back in the 1970s (unsuccessfully), and we know that whatever else he is, obsessive is certainly a deep part of his makeup.

[anne]

Tax code what-what what-what?

[Barkley Rosser]

anne,

Don't worry. Neither Hillary nor Obama nor McCain supports such simplification, although most economists do, with some caveats of course. Peter Lindert notes that in much of social democratic Europe one finds not very progressive tax systems, notoriously financed by heavy VATs, combined with much more generous redistributive social safety net programs to achieve much greater equality and security in those countries than one finds in the US.

Do you really want to defend a tax code that even IRS agents and tax accountants do not understand?

[anne]

Interesting choice of language, though; say what-house?

[Barkley Rosser]

anne,

I confess to not knowing what your language here refers to.
"what-house"? Say what?

For what it is worth, this is a perfectly good issue that at times has been supported by one or both political parties, but has basically been abandoned by both of them, for reasons that remain unclear to me, although one can poke at things in it that each side will not like, particularly the ending of tax breaks for favored groups by each party.

But in some sense this is the point. One ends some of the worst pure wasted time and effort and rent seeking going on in the US economy, with a potentially serious lowering of tax rates, with a good package. The only people who should really defend the current basic system are tax accountants, who, no offense to any tax accountants reading this, are probably as pure an example of rent seeking or what both Adam Smith and Karl Marx would have labeled "unproductive labor," as any profession there is. Shut those smart people down and get them doing something actually socially useful!

[anne]

Tax code what-house? Interesting thing about language, that we are so bizarrely unwilling or unable to understand they ways in which we use it. What-house? Tra la, tra la, rum tum tiddle.

[Barkley Rosser]

Oh, "what-house" refers to "White House," I guess. I am too overworked and burned out to get much humor...

[anne]

We need to learn to read what we write.

"Likewise, I happen to consider it unfortunate that Bush passed up the chance to do another cleaning of the tax code -----house in his second term the way RR did."

Tax code what-what what-what?
Tax code what-house?

[Recycled Mishmash]

The markets allocate capital much better with efficiency encouraging taxes and regulations. Increased world competition may encourage this trend.

[Barkley Rosser]

Oh, "whorehouse." Oh, are you suggesting that this is some kind of sexism or something? No, I am simply referring to the utterly corrupt nature of the special favors and interestes and rent seeking inherent in the US federal tax code. If you wish to defend the US federal tax code, be my guest.

If you wish to suggest that I am defaming prostitutes and their rights, women and their rights, Hillary Clinton as a woman, you as a woman, all the women supporters of H.C. screaming about "Denver! Denver!", sorry, anne, that is off the deep end. No dice.

[Barkley Rosser]

Actually I was insulting Texas, as in "The Best Little Whorehous" therein, given the wacko defense of Texas from our poster with the multiple personalities who does not believe that crashes of speculative bubbles can harm the economy, and nothing of the sort ever happens in The Best Little Whorehouse in...

[anne]

Imagine, can you imagine, all those women, all those women supporters, all those women supporters of a woman running for President. Imagine allowing all those women supporters being allowed to vote, let alone a woman being allowed to run for President. OMG!

Notice the language.

[Barkley Rosser]

anne,

Uh, I can imagine. And they have had the right to vote for a long time, and they outnumber men, and they have voted, and a woman was allowed to run, and indeed was the presumptive frontrunner, before she got outsmarted and out-orated by another candidate. Tough.

And, yes, as I suspected, you are seeing slams at Hillary and her supporters where there are none. This thread was NOT about any of that until you insisted on it with your assinine "what-house"? b.s.

If you wish to accuse me of slimey sexist gutter talk, go ahead, anne, but the game is up. You are just making yourself look silly on this one.

[anne]

"He was thinking, but she could tell he wasn't good at it."

[Barkley Rosser]

BTW, which "language"? "Imagine" or "whorehouse"? Just out of curiosity, is there something sexist about the latter? Or is impolite? You would prefer "brothel"? Or is politically incorrect to refer to a den of corruption by such a term?

[Great Recycled Anonymous Multiple Silly Personalities]

Barkley..."...nothing of the sort ever happens in..."

Oh, things happen there. Just noting that areas with less restrictive non safety zoning had fewer subsequent problems than more heavily zoned areas (ceteris paribus). The problems with commercial real estate in the 80s were primarily an artifact of a national disincentive to efficient capital allocation (fixed during RR's watch). Markets can be made less efficient via multiple vectors, and an inefficient national mandate can overwhelm local efforts.

Long live efficiency enhancing regs. Long live competition. Long live all of my personalities. :)