Tim Duy shares his thoughts on how the Fed will view and respond to economic conditions in coming months:
Warning: Lengthy post as my brains empties in preparation for a week on the Oregon Coast.
The data this month have been somewhat disappointing, as noted here by David Altig, and as later seen in a weak durable goods report. On the other hand, anecdotal evidence aside, data suggest that the housing market remains healthy or too healthy as the case may be. Given the overall steady stream of positive economic news this summer, this monthly blip will not dissuade the Fed from its current policy path toward still higher rates.
Let’s begin with a word on energy. Energy prices are a double edged sword at this point. One edge is inflationary, while the other depresses demand. Given, however, that we have had little indication that the Fed has shifted its thinking on the underlying economy (in a word, solid), policymakers will keep their eyes trained on the inflation side of the sword. Indeed, the most recent run in both oil and natural gas suggest upward price pressures will continue and intensify as the leaves start to fall. And I doubt very much that the waning days of the Greenspan Era will be characterized by an easing of inflation vigilance. Chicago Fed President Michael Moskow (channeled via Mark Thoma) pretty much laid down the gauntlet on that issue:
''Core inflation is now at the upper end of the range that I feel is consistent with price stability,'' Moskow said ... ''Appropriate policy means that we continue to reduce accommodation and return to a neutral federal funds rate,'' ... Moskow didn't give an estimate of the neutral rate that would keep the economy growing without spurring inflation. … ''If we do not remove that accommodation, or raise rates, then you risk significantly higher inflation in the economy,'' he said … ''inflation this year and next is likely to come in at the high end'' of the Fed's forecast of 1.75 percent to 2 percent...
In light of the data, energy prices, and Moskow’s comments, consider the calendar for the rest of the year. The FOMC meets again on September 20. I, along with everyone under the sun, expect another 25bp with similar language. The next meeting is on November 1, after the Q3 GDP report. Note that economists are looking for something in the 4+% range. Let’s assume that the inventory story from the Q2 report was overblown and, given that car makers still can’t move a vehicle without bargain pricing won’t be rebuilding stocks any time soon. So cut that number to 3.5%, or even 3%. Given the underlying price pressures stemming from energy and, depending who you talk to, low unemployment rates, the Fed would take even such a weakened GDP report as license to move again in November. And unless we see some radical change in the economic outlook, the 3Q GDP report will also carry forward to a December rate hike. Happy holidays to all.
So I see the calendar as supportive of another 75bp this year – which will come close to cutting the yield curve to zero unless long term rates start to move – and I see no indications from Fed officials to tell me that this story is wildly wrong.
The Fed appears to be sending out other indications that the plan is still to drain excess liquidity from the financial system, or in Fedspeak, remove the accommodative environment. First, from Greenspan’s speech today at Jackson Hole:
“Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”
I read this as another warning that the days of easy money are drawing to a close, at least from the Fed’s perspective. This isn’t simply a prediction either; the Fed actually has something to say about liquidity. Greenspan sees the potential for a happy ending:
“If we can maintain an adequate degree of flexibility, some of America's economic imbalances, most notably the large current account deficit and the housing boom, can be rectified by adjustments in prices, interest rates, and exchange rates rather than through more-wrenching changes in output, incomes, and employment.”
Of course, not all interest rates are cooperating with this plan, as one of my favorite graphs from the Wall Street Journal illustrates just so clearly:
The narrowing yield spread has been the topic of endless posts, and probably reflects no single cause. A number of factors are likely at play, including foreign capital flows (here and here), weak global investment demand (here), and a “perception of abundant liquidity.” Regarding the last, one has to wonder if financial market participants are not entirely convinced that the Fed will continue to raise rates and narrow the spread, or, if the Fed did so to the detriment of the economy, it would quickly reverse course to support financial markets – the “Greenspan put.” To me, the latter is not a given this time, especially in an environment of rising energy prices.
Regarding those higher energy costs, one does not have to be a peak oil follower to believe that lack of investment in recent decades has left open the possibility of sustained higher prices for the near future. If indeed energy prices are sending such a signal, then market forces will kick into action, shifting resources into energy investment and conservation. This is not, however, a straightforward transition – today’s carpenter in Orange County will not suddenly be shifted to building natural gas pipelines in northern Canada. Today’s SUV owner will not be jumping into a hybrid tomorrow. As the economy adapts to a new energy environment, these fundamental structural frictions imply lower productivity. Again, more reason for the Fed to keep its foot on the break.
And, suppose I am wrong and higher energy prices are simply a bubble waiting to collapse. The sudden shift would take away some inflationary pressures, but send consumers back into the malls at a time when the Fed already believes underlying growth is solid….you can’t win for losing on this one. Moreover, regardless of energy costs, as I opined in an earlier post, the low interest rate environment and the willingness of investors to send capital into the housing markets implies a risk that the Fed will have to strangle the non-consumption sectors of the economy – which don’t amount to much anymore – in order to keep inflationary pressures at bay.
Couple the Greenspan comments with this little gem from yesterday’s Wall Street Journal (subscription):
The Federal Reserve Bank of New York will meet with Wall Street banks next month to discuss the still relatively opaque market for credit derivatives.
The market is a young but rapidly growing one where traders and investors use the derivatives to buy and sell protection against defaults. Trading volumes have soared, but back-office functions needed to make sure trades get completed haven't kept up with that growth.
It is these so-called settlement issues that the New York Fed wants to discuss with the bankers on Sept. 15. New York Fed President Timothy Geithner sent a letter to dealers on Aug. 12 inviting them to meet on "how best to address a range of important issues in the credit-derivatives market."
While those issues appear technical, they are essential to keep losses from snowballing into more systemic problems when the markets are volatile.
To be sure, I wouldn’t want to blow such news of such a meeting out of proportion. The long lead time between the invite and meeting implies that no crisis is imminent. Instead, the Fed is showing a healthy concern that the not all markets are prepared for the eventual end to “abundant liquidity.”
But again, my point here is that the Fed has some control over “abundant liquidity” in the economy. I doubt that it is coincidence that these warnings continue to emanate from Constitution Ave. during a period of (continued) monetary tightening that does not appear to be entirely reflected in credit markets. In short, regardless of the possibility of a recession in 2006, I still see the Fed as laying the groundwork for continued monetary tightening, even as they see the possibility that financial markets are not entirely prepared for that outcome.