Tim Duy's Fed Watch:
The next FOMC meeting is just a week out, and market participants still lack a firm consensus on the path Greenspan & Co. will choose, but, as reported by David Altig, the tide has turned in favor of those who see another rate hike in the near future. In a similar vein, this quote from Saturday’s Washington Post likely summarizes the Fed’s thinking at this point:
If Federal Reserve policymakers had to vote today, they'd probably raise short-term interest rates a notch out of concern that Hurricane Katrina could harm the U.S. economy more by boosting inflation than by slowing growth.
I would have to agree. Recent Fedspeak and data give little reason to believe that the FOMC is ready to change course, despite Katrina. While not discounting the real suffering of those affected by this disaster, Fed officials appear to be more worried about inflationary pressures rather than weak demand.
The much awaited speech by Chicago Fed President Michael Moskow was decidedly hawkish (see Mark Thoma here). Perhaps more interesting was San Francisco Fed President Yellen’s speech, which was widely viewed as less hawkish than Moskow (see William Polley here). I tend to agree; Yellen appeared more cautious than her Chicago colleague. But some little noted commentary places Yellen in a different light (I can’t take credit for spotting this; it was passed on to me by a contact). Take a look at Yellen’s previous speech on July 29. On that day Yellen thought:
A final factor impacting the inflation outlook is the degree of slack in the labor market. Right now, the unemployment rate is relatively low: at 5 percent it’s near most estimates of the so-called natural rate. But other measures—such as the employment-population ratio, a survey of job market perceptions, and industrial capacity utilization—suggest that some slack still remains.
Just a few weeks later, AFTER Hurricane Katrina, Yellen has a different view:
As we assess the likely behavior of wage pressures going forward, we must also factor in the influence of slack in labor and product markets. The decline in the unemployment rate to 4.9 percent in August, coupled with some improvement in measures such as the employment-population ratio and industrial capacity utilization, suggest that while a "whisker" of slack may still remain, we probably can't count on slack to hold inflation down.
Placing these paragraphs side by side, it appears that Yellen has reassessed the degree of slack remaining in the economy – and her conclusion is undeniably more hawkish. Likewise, from July 29:
Looking at the big picture elements—growth, employment, and inflation—I’d say things are in reasonably good shape. Over the past two years, the nation’s output growth has been pretty steady, averaging just over four percent; this is solidly above trend, which, by most estimates, is around three and a quarter to three and a half percent.
Beginning on the real side of the economy, the nation's output growth has averaged about three and one-half percent over the past year, a rate that is moderately above trend, which is now probably around three to three and a quarter percent.
Yellen appears to have settled on the lower estimate of potential growth, possibly a result of slowing productivity growth. Indeed, just a day earlier, we were greeted with news that second quarter productivity was revised downward and labor costs revised upward. This shift in Yellen’s language is subtle but important as it again suggests Yellen sees less slack in the economy compared to just a few weeks ago. So, in a nutshell, while Yellen may appear less hawkish than Moskow, she appears more hawkish than before Katrina, suggesting an increased willingness to stick with the current policy of “measured increases.”
Monday we also heard from Dallas Fed President Richard Fisher in something of a surprise speech. Everyone needs to take a look at this speech. I expect many different opinions. Simply put, Fisher is shaping up to be the most enigmatic Fed official in recent memory. Recall that Fisher first broke onto the scene with his famous proclamation that the Fed is in it “eighth inning” as far as rate hikes are concerned. It soon became clear that the remainder of the FOMC did not share this view. Now, according to Bloomberg:
The Dallas Fed said as recently as Friday that Fisher would not be making any public appearances this week. Bank spokesman James Hoard said the speech was given at 1:30 p.m. local time in Austin, Texas, at a private event that wasn't open to the public or reporters.
Turns out Fisher spoke quite a bit about the economy, and it became necessary to post his speech on the Dallas Fed website. He sounds like he is ready to pause:
When it comes to Katrina and the U.S. economy, my inclination is to read, listen and watch and not rush to judgment about how the disaster will impact the economy or how monetary policy ought to respond.
This caution, however, does not stop him from listing a litany of reasons to expect little economic impact:
You might recall that a powerful earthquake struck Kobe, Japan’s second largest port, in January 1995, causing $110 billion in damage to a city that handled 30 percent of the nation’s trade. In addition to killing 5,500 and leaving 300,000 homeless, the quake destroyed 75,000 buildings and damaged another 200,000. It took two years to rebuild. The impact on the Japanese GDP, however, wasn’t all that big.
The hurricane’s damages, as we all know, were significant in absolute terms—estimated at up to $200 billion. We’ve all seen television footage of thousands of destroyed and damaged buildings. Up close, it looks overwhelming. But it is important to bear in mind that Katrina’s estimated physical losses amount to only a third of a percentage point of national wealth.
Among the American economy’s strengths are its size, diversity, interconnections and resiliency. I fully expect the economy to rebound from this disaster—as it did after the Sept. 11, 2001, terrorist attacks. And the Northridge, California, earthquake in 1994. And Hurricane Andrew in Florida in 1992.
And he is not sure what to think about inflation:
It is clear, however, that a period of price volatility cannot be avoided for energy and other commodities processed, stored and transported along the Gulf Coast and the mighty Mississippi. The headlines have been full of news about gasoline climbing above $3 a gallon, although crude oil prices have already receded from their peaks. The massive effort to rebuild the Gulf Coast will create additional demand for lumber, steel, cement and other building materials. With so many prices in flux, our inflation measures will be tricky to read over the coming months.
I find this somewhat remarkable. Given that he clearly sees rising prices, how exactly are inflation measures tricky to read? Interestingly, Fisher also has a message (threat?) for Congress and the President:
While uncertainty surrounds Katrina’s effects on economic growth and core inflation, one thing is clear: Congress and the executive branch are acting swiftly to provide emergency funding for the affected areas. So far, the federal government has authorized more than $62 billion for recovery efforts. I have asked my staff to carefully monitor this spending. Obviously, the political authorities, not the Federal Reserve, have the power of the purse. I pray they act wisely. With the nation’s already large fiscal deficits, I personally believe it would be ill-advised for the Fed to monetize any fiscal profligacy.
Fisher clearly does not want the Fed to accommodate fiscal deficits – it is almost as if he is saying that if the Fed continues to raise rates, Congress and the President have only themselves to blame.
There are some other fun bits to Fisher’s speech, but I will leave additional parsing to others. Here is my take on Fisher: He is a dove, pure and simple. He would stop raising rates yesterday if he could. But he recognizes that he is a maverick voice on the FOMC, and consequently tries to stick to the party line, which would be, in my opinion, to downplay the impact on economic activity and play up the inflation story. But his heart just is not in it.
The other key insight into Fed policy comes from the Beige Book, which last week reported that prior to Katrina, all districts except Boston saw increased economic activity, tightening labor markets, modest wage gains but rising benefit costs, and, possibly most importantly:
Higher energy costs were reported by almost all Districts, and energy-intensive industries were able to pass some of these costs on to consumers in the Atlanta, Boston, Cleveland, Chicago, Kansas City, Minneapolis, Philadelphia, and San Francisco Districts.
Granted, all of this is pre-Katrina. But I imagine that anecdotal evidence collected today would have the tone of that in today’s Wall Street Journal article, “Manufacturers Gear Up After the Storm.” Notably:
But while rebuilding hurricane-ravaged regions will eventually mean more orders, it's also bringing more immediate supply glitches and rising prices, particularly for petroleum-based raw materials. Certain manufacturers are building inventory of steel, plastic resins and cardboard boxes and such stockpiling could eventually lead to even higher prices in the near term. The result is an uneven picture, as certain manufacturers gear up to produce more, while also facing negative cost and supply-related fallout from the storm.
What an accurate description of the Fed’s conundrum. While some demand pressures fell (at least temporarily – energy prices are pulling back from their highs) as a result of Katrina, others look poised to strengthen, all in the background of higher prices from a shock to the nation’s productive infrastructure. Sounds to me like the recipe for higher rates.
Of course, there is time between now and next week for incoming data to sway the Fed. But I suspect that data will have to be significantly out of line with expectations to steer the Fed from its current course. Of course, I have trouble calling a rate hike a sure thing – simply too much uncertainty at this point. As I see it, the mostly likely reason for a pause at this point is to take an opportunity to wait for more data.
I think, however, that the Fed will find this a weak excuse to pause. Fedspeak (at least 3 out of 4) so far has shown concern for tight labor markets and rising energy costs – a signal that FOMC members are looking to get ahead of price pressures. So considering the way the Fed tends to look at the economy, and the possible inflationary pressures resulting from Katrina, the Fed is mostly likely poised to pull the trigger again next week, despite the devastation in the Gulf.