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Friday, May 13, 2005

The Art and Practice of Fed Watching

I am pleased to announce a regular feature at Economist's View.  Tim Duy, whose qualifications are noted  here, has agreed to resume his formal role as Fed Watcher for us on a regular basis. Here are Tim's thoughts on the art of Fed Watching:

Raised From The Dead

I seemingly gave up my career as a Fed Watcher more than three years ago, choosing instead to reinvent myself as a local and regional economist in an effort to build a life in the Pacific Northwest (I am hoping global warming increases rain in the region. I understand there is a 50-50 chance of that outcome). Under some congenial prodding from Mark Thoma, however, I am warily putting my feet back in the water.

Some initial observations on Fed Watching, so I can establish something of a baseline:

1. I do not claim to have any special contacts with members of the Federal Reserve. To be sure, I know economists who work or have worked at the Federal Reserve Board of Governors or District Banks, but I am not pumping them for inside information.
2. I do not believe that there are mountains of secret information about Fed policy waiting to be discovered. Of course, on occasion a loose piece of information may slip via a private conversation from someone closely connected with the Fed. But such slip ups are relatively rare, especially as the Fed has become increasingly transparent.
3. As a corollary to point 2 above, I am amazed that investment firms will pay thousands of dollars for the inside scoop on the Fed. My recommendation is to buy a subscription to the Wall Street Journal. Greg Ip is more likely than anyone else to get the story right (except me, of course!). I expect some angry comments back on this one.
4. The secret to remember is that Fed Watching is not about your interpretation of the economy or what you would do if you were a Board member. That approach will lead you down a bad road. The secret is to interpret the data as the Fed sees it, and remain agnostic about whether the policy is wrong or right.
5. The worst screw ups will happen when the Fed switches gears in their policy stance. The Fed Watcher must both anticipate a turn in the economy and the Fed’s timing of any reaction. Given that economists have correctly predicted something like 8 of the past 5 recessions, a shift in the business cycle will likely leave the Fed Watcher bloodied (been there, done that).
6. One should be aware of what is happening on Wall Street, but not be overly influenced by the day to day noise. It is easy to get carried away in the hype.
7. Read the speeches of Fed officials, particularly Board members. Speeches from District Bank Presidents may be interesting and insightful, but policy is made in Washington (New York is the exception to this rule).
8. Everything will change next year. Be wary – no matter who replaces Greenspan, he (or, in a bow to political correctness, she) will be fresh blood, and thus a mystery. Uncertainty is the bane of financial markets.

Today’s speech by Vice Chairman Ferguson provides some great insights into Fed psychology, notably the following:

Does globalization imply a greater need for the international coordination of macroeconomic policies? Let me begin my answer by asserting that explicit coordination of policy setting across countries is not likely to happen in the foreseeable future, and I would argue that such explicit policy coordination would not be desirable. Policymakers have to be able to react quickly in many circumstances, and it makes no sense to delay needed actions in order to achieve international consensus, particularly when the potential benefits from coordinated action are small relative to the potential costs of delay. Experience has shown that the best outcomes are achieved when each country's policy focuses on domestic stabilization.

Fed policymakers keep a careful eye on global developments, to be sure. But policy remains focused on domestic stabilization. And also, all economies should maintain a similar focus. This is, of course, bad news for Nouriel Roubini and Brad Setser, who have argued that international coordination is necessary to alleviate global imbalances. It appears that policymakers, at least from the monetary side – and likely from the fiscal side as well – do not share similar views.

So the Fed will keep watch on the current account deficit, and consider how to respond to the challenges a sudden stop of capital would create, but are unlikely take policy action directed toward the current account. Likewise, there may in an asset bubble in the housing market, but don’t expect the Fed to react to that, at least not before it bursts.

What to look for then? Growth, jobs, and inflation. Boring, I know, but these are the tried and true friends of any Fed Watcher. The Fed is clearly not as concerned about the pace of growth as market participants have been – and the Fed looks to be vindicated by the job, trade, and retail sales reports, all of which suggested stronger underlying demand than expected. Moreover, I would be willing to bet that some policymakers will become nervous as the unemployment rate closes in on 5%. Eventually, someone will say “NAIRU.” At the same time, while incipient inflationary pressures may be building (again, from the Fed’s perspective), no red flags are waving. Altogether, the stage is set for a continuation of the current policy. Little blips here and there in the data won’t deter the Fed from its current mission. Significant shocks, which could be either inflationary or deflationary, will be necessary to get the Captain of the USS Fed to change course just yet.

Oh, yes, the Fed may have to change course if they over tighten….given recent noise of trouble in the land of hedge funds, I get increasingly nervous watching the yield spread tighten (collapse?)…further fodder for posts down the road.      

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