Tim Duy with a Fed Watch:
Read His Lips, by Tim Duy: Bernanke & Co. want to pause. They want to pause badly. We were supposed to have figured it out when the minutes of the last FOMC meeting were released, and when the point about an imminent pause was reiterated by San Francisco Fed President Janet Yellen. Financial market participants, however, seemed unwilling to fully accept that a pause would soon come – at least that is the story told by the rebound in expectations for a June rate hike reported by David Altig. So Bernanke came to the table yet again to make clear that we should NOT expect the Fed to keep blindly raising rates:
The FOMC will continue to monitor the incoming data closely to assess the prospects for both growth and inflation. In particular, even if in the Committee's judgment the risks to its objectives are not entirely balanced, at some point in the future the Committee may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook. Of course, a decision to take no action at a particular meeting does not preclude actions at subsequent meetings, and the Committee will not hesitate to act when it determines that doing so is needed to foster the achievement of the Federal Reserve's mandated objectives.
So much to think about in that little paragraph. But first, a recap of some central features of the Fed’s expectation of economic activity in the back half of this year:
- A cooling housing market will weaken household’s resolve, or at least their ability, to sustain the recent pace of consumption expenditures.
- Continued job creation and solid investment spending, however, will cushion the economy from the negative impacts of a housing induced consumption slowdown.
- Strong productivity growth and intense competition will hold inflation and inflation expectations in check even as the economy edges up against capacity constraints. The capacity constraints should ease later this year as the economy slows under the force of point #1 above.
Given that this is how the Fed expects the economy to evolve in the back half of this year – an expectation based on the lagged effects of monetary tightening already in place – policymakers want to hold up at 5% to see if this indeed is how the economy evolves. The trick for the Fed watcher is to determine how incoming data will affect the Fed’s outlook.
My sense is that market participants (me included) have been somewhat underestimating the Fed’s resolve to bring policy to at least a plateau (again, refer to the flip-flopping in the fed funds futures market). For example, recent inflation data and rising energy prices appear to be having less of an impact on policy than I might have guessed. In retrospect, the lack of response is not such a mystery: There is simply nothing that the Fed can do about last month’s inflation. The point of inflation targeting is not to shift policy for every move in a lagging indicator. The point is to shift policy in response to changes in the central bank’s forecast of inflation. For the FOMC, the forecast for future inflation hinges more on the forecast for demand growth than on the lagged impacts of past inflation.
While that might explain the apparent lack of response to the March CPI report, what about the jump in new home sales, or the rebound in durable goods orders? On the former, the March sales report looks like the outlier among recent data; the trend still supports the contention that the housing market is cooling. Similar evidence can be found anecdotally in the Beige Book. The housing story is not reversed by one report. Regarding durable goods, the trend in nondefense, nonaircraft capital goods orders (note also the steady rise in backlogs), is solid but not explosive. Again, this is consistent with the Fed’s outlook. They expect cooling in consumption, not investment spending.
Policymakers also find support for the inflation under control story from the Beige Book:
Many Districts describe firms as attempting to raise selling prices but having mixed success, with price increases generally either smaller than the cost increases or less widespread. Richmond, Cleveland, and Chicago, for example, mention manufacturing firms' limited ability to recoup higher costs; Boston and Dallas say competitive pressures are constraining some price increases, and Atlanta notes that the ability to pass on cost increases varies across firms, depending in part on the strength of demand and contract arrangements…Wages continue to move up, but only a few Districts--New York, Dallas, and Kansas City--mention a pickup in the pace of raises, while Philadelphia cites firms more often paying in the high end of salary ranges.
Housing is slowing, investment remains solid, inflation looks contained with only one errant report. The reality seen by FOMC members appears pretty close to their expectations. Why not hold up at 5% to see if the consumption spending follows in line with the housing slowdown?
Simply put, Bernanke & Co. have faith in their models of economic activity. Not just a little faith either. Faith enough to pause even if the “risks…are not entirely balanced.” Again, Bernanke is warning that the continued use of this phrase in the FOMC statement does not guarantee future rate hikes. But he is also placing a bet – a big bet – on the economy. The risks are balanced toward inflation – there is no shortage of warning signs in the Beige Book:
While Cleveland's [transportation] contacts continue to express concern about fuel costs, many now believe that they can increase their base rates, given the strength of demand.
Production capacity for mining equipment in the Chicago District is reportedly booked through 2007.
The commercial real estate outlook appears to be predominantly positive across the reporting Districts--none report weakening commercial demand.
Dallas, Kansas City, and San Francisco contacts see little or no excess capacity in the energy sector. In particular, Kansas City contacts say that shortages of equipment and workers are constraining drilling activity; pipeline capacity is also limited in some areas. In the Minneapolis District, almost all open mines are producing near capacity.
While no District reports that cost increases have intensified in the latest survey period, Kansas City says that firms were having greater difficulty obtaining steel and aluminum.
Services firms are also reported to be facing higher costs, notably for utilities, shipping, and transportation.
Many of the pressures do not appear to be letting up. Oil solidly pierced the $70 mark, and metals continue to make new highs. Retail gasoline prices are over $3 per gallon in many areas weeks before summer driving season. The job market looks to be holding strong. But the Fed does not appear to be overly concerned about these trends – and not without good reason. Rising commodity prices and tightening labor markets are something we have been living with for some time, and the pass through to core inflation has been minimal. And one can argue that while rising commodity prices are a signal of strong global demand activity, the lack of inflation is evidence that the growth is not excessive.
Of course, one can also argue that the lack of pass through reflects appropriate monetary policy – slow but steady rate hikes on the part of the Federal Reserve. Will the rosy inflation outlook continue to hold if the Fed eases off the break? It’s not like the rest of the world is tightening policy at a breakneck pace. And is it really all that wise to bet against the American consumer? Lenders are working overtime to keep consumers borrowing (WSJ subscription).
The willingness to pause even if the “risks…are not entirely balanced” also suggests something about Bernanke’s view of the costs of missing the policy mark: he views the cost of accelerating inflation as less than the cost of excessive slowing. Or the magnitude of the latter error would be greater than the former. A case of once bitten, twice shy, considering the Fed’s underestimation of the slowdown in 2000? Alternatively, he might feel it is easier to correct for an inflation overshoot than a growth undershoot. I am confident that the blogging community could debate this topic for weeks to come.
A cynical person might suggest that a Bush-appointed Board of Governors is simply not all that interested in hiking rates as we approach the November elections, especially given recent polling data. Luckily, I am not a cynical person.
No, I am an optimist. Monetary policymakers see signs of slowing in the housing market, they do not see excessive growth elsewhere, and inflation looks contained. They are comfortable with – and not easily swayed from – the idea of pausing a 5% to see if overall activity does ease as expected. They want to make clear their inflation vigilance while making a bet that the slowing will occur before inflation creeps into the system. They are walking a tightrope. I wish them good luck, content to watch for data that either strengthens or threatens their resolve to pause.