Fed Watch: Dejá Not

Tim Duy, recently known as Mr. Contrarian for his call¹ that the Fed would continue to raise rates even after Katrina, has his latest Fed Watch:

Thankfully, Hurricane Rita proved not to be as destructive as feared and largely spared critical refinery capacity. We can be sure the Fed breathed a sigh of relief as well – one supply shock to the nation’s infrastructure is enough for the year.

The Fed’s last statement was widely parsed, with the general feeling that Katrina left the Fed feeling more hawkish than widely expected (see Mark Thoma’s roundup of commentators). Many noted that the Fed still believes monetary policy to be accommodative, that, in addition to energy, “other costs” are now fueling inflationary pressures, and inflation expectations are now just “contained,” not “well” contained. And, of course, that the Fed expects Katrina to have minimal lasting impacts on demand.

Many, I believe, expected the Fed to be more concerned about growth prospects, especially in light of a rather sharp drop in consumer confidence. With this in mind, reread this paragraph from the FOMC statement:

The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”

Note the subtle but important shift from the beginning to the end of this paragraph. The FOMC believes that with measured removal of monetary accommodation will help meet the twin goals of sustainable growth and price stability. As always, of course, they remain data dependent. If economic prospects change, they will act to ensure price stability, not sustainable growth.

Of course, the two goals are the same if the economy is subjected to demand shocks. Supply shocks, however, are a different matter entirely. This is where I believe many have missed a key element of Fed thinking. They do not view the Katrina induced energy disruptions as a demand disturbance. They view Katrina more as a 70’s-style supply shock, with the possibility of triggering both inflation and weak – or even recessionary – growth. And I believe the Fed is explicitly saying that in such a stagflationary situation, they will choose price stability. The short run blow to growth is less important than keeping long run inflation expectations in check. Or, in other words, they believe additional tightening now will extend the length of the recovery by keeping inflation in check and avoiding more painful hikes in the future. Of course, not everyone agrees with the Fed’s position – be sure to read James Hamilton’s critique of recent policy.

Regarding data dependence, the FOMC clearly believes that Katrina will have little demand impact in the long run. That implies they will discount any negative numbers that appear to have been distorted by Katrina, with the exception of inflation numbers, a statistic the Fed is clearly nervous about. I suspect this will frustrate many analysts to no end.

More evidence of the Fed’s increasingly hawkish stance can be found in this curious report from Reuters. I wonder how much play it will get; in my mind it is important. Repeating part of what Mark Thoma posted earlier:

U.S. Federal Reserve Chairman Alan Greenspan told France's Finance Minister Thierry Breton the United States has "lost control" of its budget deficit... "'We have lost control,' that was his expression," Breton told reporters after a bilateral meeting with Greenspan. "The United States has lost control of their budget at a time when racking up deficits has been authorized without any control (from Congress)," Breton said. "… Breton said: "The situation that is creating tension today on the currency market ... is clearly the American deficit." ... Breton added that after hearing Greenspan talk about inflation: "One has the feeling -- though he didn't say so -- that interest rates will probably continue to rise slightly until his departure."...

On the surface, this is a stunning breach of etiquette. These are private conversations for internal use, not for public dissemination. In fact, it is such a breach that one wonders if Greenspan asked that his thoughts be leaked to the press in effort to make a signal he doesn’t feel he can make directly. In any event, we should likely take Breton at face value and assume he is accurately reporting his conversation with Greenspan. And the message is the clear intention to keep tightening in the face of inflationary pressures. I interpret “continue to rise slightly” as additional 25bp pops.

One of those pressures is fiscal deficit spending, with Katrina driving the latest round of profligacy (I suspect that those impacted by Rita will want their share too). It is not out of the question that Greenspan is sending a warning to Congress that he will not let the Fed be pulled into monetizing the deficit. Recall that we saw similar comments by Dallas Fed President Richard Fisher. There is a real possibility that the Fed is gearing up to lean against the wind of fiscal spending.

I continue to think that Greenspan & Co. are sending increasingly not-so-subtle messages that the days of low interest rates and easy policy are at their end. This is a message for Congress and the Administration, not just the financial markets. Indeed, something unexpected may be happening – a concerted effort to end any sense of a Greenspan-put in the markets or the economy as a whole. It will undoubtedly be interesting to watch this chapter in Fed history play out.

UPDATE (by Mark Thoma):  With Greenspan's comments on the deficit over the weekend, the recent concern expressed by Dallas Fed President Richard Fisher, and this today from Chicago Fed president Michael Moskow, it is clear that the Fed is becoming increasingly concerned about the fiscal deficit.  I hope to post more about this later, but here's a quick update for now:

Moskow: Fed still has room to tighten, MarketWatch:  The Federal Reserve has more room to raise interest rates, the president of the bank's Chicago branch said Monday. Michael Moskow said excess capacity in the nation's economy makes removing borrowing accomodation necessary. ... Moskow said the impact from the storms in holding down output and pushing up prices probably was temporary. He will continue to monitor, in particular, government spending that came in response to Katrina. A pledge for increased outlays from President Bush and Congress led many private-sector economists to stick with or increase their 2006 economic-growth projections, despite the many uncertainties still posed by Katrina and, to a lesser degree, Hurricane Rita…

And there was also this from Fed Governor Susan Bies:

Fed's Bies warns about energy prices, MarketWatch:  Higher energy prices are threatening to have a ripple effect on the prices of other goods, Federal Reserve Governor Susan Bies said Monday. "The longer the prices stay higher, the more likely there will be an impact on prices in general," Bies told reporters following an international bankers conference. Bies also said she was relieved that Hurricane Rita didn't wreak as much havoc as feared. … The Fed policymaker said she was particularly heartened that the storm didn't take a major toll on Gulf Coast energy infrastructure. … Although the impact of both hurricanes Rita and Katrina will wallop local economies for weeks or perhaps months to come, the effect on the U.S. economy should be minor, Bies said. "At this point, we're still seeing an underlying resilience in the economy," she said…

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¹Tim's Fed Watches between Hurricane Katrina and the most recent FOMC meeting are at 9/18, 9/13, 9/5, and 8/30.