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Monday, June 02, 2008

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:

Duy6108

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.

    Posted by on Monday, June 2, 2008 at 12:24 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (29)

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