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Friday, April 14, 2006

Fed Watch: Policy in Transition

Tim Duy has a Fed watch:

Fed Governor Donald Kohn’s speech today provides a relatively clear elucidation of what I believe is the consensus view among policymakers (see also Mark Thoma’s reporting of Fed speeches): Growth is expected to moderate in the months ahead, easing inflationary pressures and allowing the Fed to pause in the near future. But “pause” does not mean “done.” Policymakers still hold an inflationary bias, and they want to make this clear to market participants.

Kohn’s speech begins with the familiar story of the US economy to date: Output growth has continued apace, driving down the margin of underutilized resources. Still, inflation expectations remained contained, the result of remaining underutilized resources, import competition, and moderate wages gains. Critically, Kohn expands on the concept of “underutilized resources,” a key phrase in light of the drop in the unemployment rate, making clear that the tight labor markets do not necessarily imply higher inflation:

Nonetheless, with labor markets tightening, some pickup in compensation increases for the broad measures would not be surprising. Nor would a pickup necessarily be inflationary, given the very good growth in labor productivity that we have experienced in recent years…. we cannot directly observe full capacity of either labor or production resources; consequently, we can never be certain what level of activity represents the full utilization of capacity…. In addition, measurement issues aside, the empirical evidence of the past half-century suggests that the relationship between utilization and inflation can shift over time.

True, if the economy continued to grow above potential, the margin of utilization would continue to tighten, thereby increasing inflationary pressures. The key, then, is what are policymaker’s expectations about growth in the months ahead? Policymakers continue to expect that growth is set to moderate:

The available evidence suggests that the pace of economic expansion may moderate a little from its average over recent quarters, keeping resource utilization in line with recent levels. Maintaining economic growth around this pace will likely reflect a balancing of opposing forces. The rise in interest rates we have experienced will tend to restrain demand, offsetting the effects of sustained economic expansion in our trading partners and the reduced drag on U.S. growth from oil prices, assuming that those prices roughly flatten out as participants in futures markets seem to expect.

Remember that policy is forward looking. Assuming a May rate hike, policymakers recognize that 400bp of tightening will be in the system, the lagged effects of which will be felt for months to come. This will give policymakers pause before continuing to blindly hike rates into the second half of this year. This is especially the case given that the housing channel is working as expected:

If the past is any guide, the effect of rising interest rates is likely to be felt most visibly in housing markets…Already there have been signs that housing demand has begun to moderate. Sales of both new and existing homes are down substantially from their levels last summer, and information on mortgage applications and pending home sales point to further softening in the next few months. With demand slowing, house prices also seem likely to decelerate. Indeed, we are beginning to see hints of moderation in some of the data on housing prices…. the slowdown in house price increases could well hold back growth in consumption spending on a wide variety of goods and services.

I continue to argue that the Fed did not act to pop a housing “bubble” directly, but did expect that tightening would work its way through the housing market to consumers. With this process likely underway, the Fed is thinking about transitioning to a new policy stance rather than risk overshooting.

In this context, the data should be read as to whether or not it changes the Fed’s view of output growth or inflation in the second half of the year. There is, of course, uncertainty surrounding the outlook. A critical one is the outlook for energy prices. Kohn anticipates that oil prices will hold near current levels, as suggested by futures markets. Given tightening resource constraints, unanticipated increases in energy prices will likely trigger additional monetary tightening, especially if signs of consumption slowing fail to materialize between now and June. Indeed, Kohn makes clear in his conclusion that the Fed will be quick to respond to any indications that inflation is likely to head to the upside of the forecast:

At this juncture, given the apparent strength in demand and the narrowing margin of unused resources, I am focused on making sure that inflation and inflation expectations remain well anchored. A tendency for inflation to move higher would put economic stability and the long-term performance of the economy at risk.

In short, recent data reveals that the economy enjoys enough momentum to justify another rate hike in May. That is something of a given at this point; the real question is the June meeting. I continue to feel that the Fed would like to take a pass at that meeting on the expectation of slowing economic growth, but make it clear that the odds of tightening beyond that remain about 50%. The question is whether the data will continue to support such a move, especially since policymakers would likely risk somewhat higher interest rates now to avoid even more aggressive hikes later. Particularly important is the relative impact of possible higher commodity prices versus expectations of slowing demand growth.

Another possible path comes to mind. As the play on housing becomes less stimulative, will market participants find yet another asset play to maintain household wealth? The rise in financial vehicles to access the commodity boom (WSJ subscription) is something to watch – the potential for even higher commodity prices coupled with higher demand growth is almost certainly the recipe for more aggressive rate hikes, and would likely be an unwelcome surprise for Bernanke and Co.

Update: See also Greg Ip of the Wall Stree Journal who leads with:

Financial markets increasingly expect the Federal Reserve to raise interest rates in May and keep lifting them into the summer. But not all Fed officials are convinced that much action will be needed.

Tim adds:

Fed officials are signaling they want to bring the rate hike cycle to at least a temporary pause in the near future; they simply are not expecting to raise rates past the May meeting.  But they need to maintain public vigilance against the possibility that inflation pressures surprise on the upside to maintain credibility.  That implies a willingness to raise rates further, if necessary.  Some market participants may be misinterpreting that vigilance as guarantees of future rate hikes.  This is not the case.

    Posted by on Friday, April 14, 2006 at 12:12 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (3)


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