Tim Duy with a Fed Watch:
Policymakers are gearing up for another 25bp rate hike at the end of the month – essentially a given at this point. Market participants are also pricing in another 25bp hike in May, although the odds have backed off a bit. Last week I said the mood on the FOMC appeared to be shifting to favor a pause at 5% on the Fed Funds rate. Soon thereafter, John Berry at Bloomberg argued that 5% was a more likely stopping point than 5.25% or higher. Sounded good to me. But then, while cleaning my office, I stumbled upon this piece that I wrote on May 14, 2001. This part caught my eye:
We will pay close attention to the Fed’s statement tomorrow. It will probably attempt to lower expectations for further rate cuts while not closing the door entirely. The Fed is definitely feeling around for the end of the easing cycle. Several governors think 4% would be a good pausing point. But April’s employment report served as a warning that the US economy could be set for a fresh downturn. It’s a warning that Fed officials will definitely take to heart..
Four percent? What in the world was I thinking? Or drinking? The bottom turned out to be 1%. Of course, I wrote this relatively early in that easing cycle, and prior to the September 11 terrorist attacks. Few economists foresaw how low the Fed would push interest rates, and I believe the piece captures the thinking of FOMC members at the time.
Still, 4% was not just a little bit off. It was way off – and illustrates the perils of looking for a top or a bottom. Accurately calling the stopping point depends on a combination of understanding the underlying policymaking process and correctly anticipating the path of economic activity. Missing either will trip up the Fedwatcher. Another example, brought to us by Bloomberg:
[Bill] Gross [of PIMCO] as far back as May has been forecasting an end to Fed rate increases. A rate of 3.25 percent to 3.5 percent ``is about all the economy can stand,'' he said at the time. The rate is currently 4.50 percent.
I do not mean to ridicule Bill Gross; one could have a perfectly reasonable, well thought out position for calling a peak (or trough) in rates, and still miss the call completely.
So, for the sake of clarity, the case for a pause at 5% hinges on the expectation that growth will slow and inflation remains in the “comfort zone” in back half of this year – essentially, the outlook of most policymakers and forecasts. Considering the substantial amount of tightening that is already making its way through the system, this outlook argues for a pause sometime in the near future to avoid a possible overshoot. At a minimum, Fed Chairman Ben Bernanke’s speech reinforces my view that a move beyond 5% is not in the mindset of the FOMC at this point. At a maximum, it leads me to shave down my expectations for a move to 5%.
The twists and turns of Fedspeak point in the direction as well. Policymakers are walking a fine line, setting expectations of additional tightening while including a dovish sounding note here and there. For example, in recent speeches, San Francisco Fed President Janet Yellen has indicated the need for further tightening:
And that brings me to the inflation situation. Specifically, this relatively low unemployment number raises the question of whether the economy has already gone a bit beyond full employment. If it has, then, with real GDP growth expected to exceed its potential rate in the first half of this year, the strain on resources could build further, intensifying inflationary pressures. Additional inflationary pressures at this point would be particularly unwelcome, because inflation is now toward the upper end of my “comfort zone.”
Later in the speech, however, she is clear that while that higher rates are necessary in the near future, policy beyond that is data dependent:
Indeed, I view decisions about the stance of policy going forward as quite data-dependent. On the one hand, I will be alert to any incoming data suggesting that economic growth is less likely to slow to a sustainable pace or that inflation is less likely to remain contained; however, I will also be looking for signs of the delayed effects on output and inflation of our past policy actions and will be sensitive to the possibility that policy could overshoot. While the Committee must always have the flexibility to respond to changing circumstances, the need for the flexibility to respond appropriately to incoming data is especially important right now.
But “data dependent” must be taken in context of expectations:
…it seems likely that growth will settle back to a trend-like pattern as the year progresses. One likely contributing factor is the winding down of the rebuilding effort later in the year. Another is the lagged effect of monetary policy tightening; in other words, tighter financial conditions will have a dampening impact on interest-sensitive sectors, such as consumer durables, housing, and business investment.
Putting it altogether suggests that Yellen is comfortable with expectations for two more rate hikes and a pause – assuming of course that the economy looks to slow to trend as expected. In my opinion, her remarks to the press after speeches sound a bit more dovish (see my last piece), but that could be the result of selective quoting by the press. In contrast, Altanta Fed President Jack Guynn sounded a more hawkish note last week:
Several areas warrant close attention. As I suggested earlier, households and businesses seem to be coping with persistently higher energy prices without a major reallocation of spending. But it’s possible we haven’t yet seen the full adjustment to the new reality of elevated energy costs. Also, we don’t yet know the full effects of the potential transitions in residential real estate markets. Despite the removal of very accommodative Fed monetary policy, credit markets are still accommodative, in my view, and this liquidity could boost the economic expansion and contribute to stronger-than-expected inflationary pressures. The relative lack of broad pricing power that’s been observed in many competitive world markets could begin to change, especially if domestic demand increases beyond present forecasts.
Boston Fed President Cathy Minehan took a more middle of the road approach today at the New England Realtors Conference:
From a macro perspective, it makes sense to worry about the potential impact on overall GDP growth of a combination of a reduction in housing construction and a decline in household wealth…. Thus, changes in residential real estate present a source of downside risk to growth. I should also note here that in recent times residential real estate markets have often outperformed expectations, a fact with which this audience is more than familiar….But the risks are not all in the direction of slower growth. Stronger growth and somewhat higher inflation are well within the realm of possibility as well. Consumption could be less affected by waning real estate markets than we expect, particularly if more consumers are working. With unemployment rates at their recent levels, some possibility exists that labor costs will begin to rise faster than productivity, which in turn could put pressure on inflation.
No one – expect maybe Minneapolis Fed President Gary Stern – sounds like they want to stop hiking rates immediately. The hawks sound too hawkish to pull back just yet. But policymakers won’t keep blindly raising rates until the bottom falls out (critics will argue that they have already missed the boat on that one). The common thread through most Fedspeak is the expectation that a slowing housing market will depress economic activity later this year. That should feed into an easing of inflationary pressures, forming the basis for a pause at 5%.
But what about the man on top? Arguably, Bernanke’s speech last night was remarkably clear. Except when it came to the policy implications. Then things get a bit tricky. Are we expected to hold at 4.75%? Or is 5.25% more of a possibility?
My initial impression of the speech is that it is more dovish than I anticipated. True, it is clear that Bernanke does not worry that the yield curve signals a “significant” economic slowdown is in the cards. This could be interpreted as a license to push rates beyond 5%. But I keep getting caught up in the next two paragraphs (so, apparently, did Greg Ip at the Wall Street Journal), in which Bernanke offers the possibility that the natural interest rate has declined. More importantly, he reminded us that this is consistent with his global saving glut hypothesis, concluding with:
So long as these factors persist, global equilibrium interest rates (and, consequently, the neutral policy rate) will be lower than they otherwise would be.
I do not see any indication that Bernanke has abandoned this theory, and the fact that he concluded with the suggestion of a lower neutral policy rate is, in my opinion, significant. Recall that the midpoint of the neutral range is often thought to be 4.5%. Unless you believe that there is a need to push rates well above neutral – which is not something I am picking up from the data or any other policymaker – it indicates a willingness to pause on the south side of 5%, lest policy become to restrictive in a world awash in excess saving.
It is worth noting that if Bernanke is sending a signal, it is not a particularly strong one, and I am not yet confident Bernanke’s colleagues share a dovish view on the neutral rate. On at least one point, the importance of central bank intervention, Bernanke spends two paragraphs rebutting the position of New York Fed President Timothy Geithner, who appears to favor higher rates to counteract the stimulative impact of foreign central banks.
In short, Bernanke’s speech leads me to shave down my expectations of another hike after next week’s. But I would like to see more Fedspeak swing around toward a pause at 4.75% before I abandon a move to 5% in June. Without stronger data, I remain hesitant to look for anything past 5% as FOMC members will likely want to sit back and assess their handiwork.