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Sunday, September 18, 2005

Fed Watch: What Will Be the Fed’s Message?

Here's Tim Duy with a Fed Watch in anticipation of Tuesday's FOMC meeting:

The Fed looks set to hike rates on Tuesday, with the markets pricing in at least an 86% probability of another 25bp pop. More interesting (assuming no surprises) will be the statement. The Fed will be walking a fine line on this one so as not to seem indifferent to those suffering from Katrina. In the end, I believe they will acknowledge but downplay Katrina’s impact while maintaining expectations of additional rate hikes. I think inflation fears will trump slowdown concerns at this next FOMC outing.

Friday, we learned that images of Katrina’s devastation and higher gas prices likely conspired to depress the confidence numbers. I will turn to that topic later. What I think is most important for policy is the sharp rise in inflation expectations, from 3.1% to 4.6%. And this comes right after two regional manufacturing indexes that both experienced sharp rises in the prices paid component. So now you have the combination of inflation pressures in the system AND an expectation of sharply higher prices among economic agents. Simply put, this is a conservative central banker’s worst nightmare.

Here is how I believe the Fed sees the story prior to Katrina: Despite rising energy prices, the impact on core-inflation has been muted (see also James Hamilton here), although at the higher end of their comfort range. The fundamental reason core-inflation is in check is because the Fed has withdrawn monetary accommodation in an effort to hold expectations at bay. Yes, I know that this makes the Fed sound like they think they are all powerful, but, well…you know.

Now, after Katrina, inflation expectations may have come unglued. Furthermore, consider this: Assuming the survey accurately represents inflation expectations, prior to Katrina, the real fed funds rate was 0.4%. After Katrina, the real rate is now negative 1.1%. In other words, policy just became a lot more accommodative, and the neutral point shifted up more than 100 bp! That is nothing short of a big leap, and whether it is temporary or not remains to be seen (gasoline prices have headed lower, but higher home heating costs are expected this winter). I think that the Fed will want to make sure this is a temporary inflation expectations reading, and that means higher rates. David Altig notes that the previous outlier in inflation expectations was a short-lived but sharp drop following 9/11. It is worth remembering that the Fed followed the attacks with aggressive rate cutting. Wouldn’t the appropriate strategy now be the opposite?

As for the rest of last week’s numbers, by and large I think they will leave the Fed with the feeling that inflation pressures are a threat; manufacturing may have slowed a bit but will soon expand under the duel influence of reconstruction and low inventories; and jobless claims have risen as expected, but this is largely a temporary and regional issue. I know this may sound “cold,” but the Fed does not make policy for specific regions or industries. They make policy for the nation as a whole.

But what about consumer confidence? The UMich Index saw a dizzying slide in September (WSJ subscription only) from 89.1 to 76. The question, however, is to what degree Katrina and gasoline impact consumers’ willingness to spend. This is different from the ability to spend. Consumers may be unhappy because the basket of goods they can purchase has shrunk (or is increasing more slowly), but that doesn’t mean they stop spending. Indeed, non-auto retail sales gained 1% in August – an annualized rate of over 12%! Even if a big chunk of that gain was gasoline, the will to spend remains intact.

A more concerning event would be for consumers to be scared into abruptly raising their savings rate. So far, we have seen little evidence that households want to hold onto a bit more of their paycheck. And even if they did, to what extent would that really change Fed policy? To be sure, many would be calling for the Fed to stop and even reverse course, but higher savings rates will be a necessary part of the rebalancing that (I believe) the Fed expects will happen at some point. Remember, the US is currently consuming roughly 6.4% (the current account deficit) more goods and services than it produces. I doubt anyone at the Fed believes such a situation can continue indefinitely.

In practice, I suspect that rebalancing will require slower demand growth to eliminate this gap – implying a risk that the Fed will raise rates higher in a deliberate attempt to hold growth lower than at any time in recent memory. I think this will come as a surprise to many, but in my opinion the Fed has been sending signals left and right that a change is coming. And, if estimates of potential growth are falling as well, as I read into San Francisco Fed President Janet Yellen’s speech last week, that change may be coming sooner than expected.


UPDATE [by Mark Thoma]: Bloomberg’s John M. Berry:  Rates are Going Up, Long-Run Target Higher than Before Katrina

The CBOT did not report the probability that the federal funds target will be raised on Friday for reasons I am unsure of, but John Berry of Bloomberg reports it as 94%.  He believes the Fed will raise rates and indicate further rates are to be expected.  In addition, though he expects some change in the language from the minutes, he does not expect the language to change substantially.  Finally, he believes the overall impact of Katrina is to raise the interest rate target that will ultimately be viewed as neutral by the Fed:

Fed Will Raise Rates and Indicate More to Come, John M. Berry, Bloomberg: Federal Reserve officials are set to raise their target for the overnight lending rate tomorrow, and financial markets have gradually accepted that the devastation from Hurricane Katrina won't deter them. Trading in 30-day federal funds futures contracts on Sept. 16 indicated that investors accord a 94 percent probability that the target would be raised by a quarter-percentage point, to 3.75 percent, compared with only a 6 percent probability of no change. On the other hand, there has been widespread speculation that officials will make some significant changes in the forward- looking portion of the statement that will be issued at the end of the Federal Open Market Committee meeting. … there are good reasons to expect no change at all in that key paragraph in tomorrow's statement. … removing the word ''accommodation'' would imply that officials believe they have raised their overnight rate target as much as their need to. … Given the level of inflation pressures in the economy, intensified by surging energy prices, that's a very unlikely conclusion for Fed officials to make at this point. Second, what would the message to the markets be if the word ``measured'' were removed? That officials were preparing to pause in their drive to move the overnight rate target to the so-called neutral level? Or that they were contemplating a 50 basis-point move at their November meeting? … the degree of inflation pressure would argue against a wording change that could be interpreted as pointing to a pause. Finally, it isn't at all likely that the balance of risks portion of the statement would be changed. … What will change in tomorrow's statement is that the paragraph explaining how the committee views current economic conditions … In other words, the officials are going to describe how they expect the economy to evolve in the wake of the hurricane. … they are likely to say … that the overall impact on the U.S. economy will be ''transitory'' and ''temporary.''… No one, including Fed officials, knows how high the overnight rate target eventually will go. It's very likely that the responses in the marketplace and in the halls of government to Katrina will make that point higher than it otherwise would have been.

UPDATE [by Mark Thoma]: Rates Falling in UK?  Here's some news indicating rates are headed in the opposite direction in the UK.  This is just for information, I don't mean to imply it will influence the Fed's rate decision:

Rate cuts predicted if growth in UK falls short, by Chris Giles and Scheherazade Daneshkhu, FT: There is a “serious risk” that economic growth will fall short of the Bank of England's forecast, forcing further interest rate cuts, Stephen Nickell, a member of its monetary policy committee, has told the Financial Times. … Mr Nickell's views are in line with those expressed in a speech on Friday by David Walton, another committee member. Together they suggest that a significant proportion of the MPC is feeling uncomfortable about its August growth forecast... Mr Nickell said he saw few signs that inflationary expectations had risen, in spite of high oil prices...

UPDATE [by Mark Thoma]: From Bloomberg:

The following are the results of the survey, conducted from Sept. 13 to Sept. 16.

                    Drop       Sept. 20  Dec. 31   Dec. 31
Firm                Measured?  Target    Target   10-Yr Yield

ABN Amro              No       3.75%     4.00%     4.25%
BNP Paribas           No       3.75%     4.25%     4.50%
Banc of America       No       3.75%     4.00%     4.45%
Barclays Capital      No       3.75%     4.25%     4.50%
Bear Stearns          No       3.75%     4.25%     5.00%
CIBC World Markets    No       3.75%     3.75%     4.05%
Citigroup             N/A      3.75%     4.00%     4.25%
Countrywide           No       3.75%     4.00%     4.70%
CSFB                  No       3.75%     4.25%     4.15%
Daiwa                 No       3.75%     4.00%     4.55%
Deutsche Bank         No       3.75%     4.25%     5.00%
Dresdner              Yes      3.75%     3.75%     4.10%
Goldman Sachs         N/A      3.75%     4.00%     4.20%
HSBC                  Yes      3.50%     3.75%     4.00%
JPMorgan Chase        No       3.75%     4.25%     4.75%
Lehman Brothers       No       3.75%     4.25%     4.70%
Merrill Lynch         Yes      3.50%     4.00%     4.25%
Mizuho                No       3.75%     4.00%     4.60%
Morgan Stanley        N/A      3.75%     4.00%     4.35%
Nomura                No       3.50%     3.75%     4.25%
RBS Greenwich         No       3.75%     4.25%     4.90%
UBS Securities        No       3.50%     4.00%     5.00%

Median                                             4.48%


UPDATE
[by Mark Thoma]:  CBOT Fed Watch:  Chance of 25 bps Hike is 92%

The chance of a 25 bps rate hike at the next FOMC meeting, according to the market's assessment at today's close, has fallen slightly from 94% on Friday to 92% today:

CBOT Fed Watch: Based upon the September 19 market close, the CBOT 30-Day Federal Funds futures contract for the October 2005 expiration is currently pricing in a 92 percent probability that the FOMC will increase the target rate by at least 25 basis points from 3-1/2 percent to 3-3/4 percent at tomorrow’s FOMC meeting (versus an 8 percent probability of no rate change):

September 13: 18% for No Change versus 82% for +25 bps.
September 14: 16% for No Change versus 84% for +25 bps.
September 15: 14% for No Change versus 86% for +25 bps.
September 16:   6% for No Change versus 94% for +25 bps.
September 19   
8% for No Change versus 92% for +25 bps.

September 20:  FOMC decision on federal funds target rate.

    Posted by on Sunday, September 18, 2005 at 10:31 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (1)  Comments (3)

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