Fed Watch: To Pause or Not to Pause

Tim Duy gives his thoughts on the Fed's recent communication with the public, and on the chances the Fed will call a halt, at least temporarily, to further increases in the target federal funds rate at its next meeting:

To Pause or Not to Pause, by Tim Duy: The statement of last week’s FOMC meeting has been parsed, diced, and analyzed every which way – see Dave Altig for a round up of various talking heads, and Mark Thoma for a side-by-side comparison of the statement and its predecessor. It appears that the Fed has done little to clarify what many believe to be an ambiguous message about the future path of interest rates.

Is the Fed suffering from a communication problem? I would say “yes,” although other, such as Jim Hamilton at econbrowser, would disagree. And I see the point; in many ways, Fed Chairman Ben Bernanke is remarkably clear. Indeed, any trained economist can readily grasp his message, which can be boiled down into one simple phrase: “It depends.”

Of course, I use the phrase “It depends” on a regular basis. It is a favorite phrase of economists, who – appropriately – need to remind others that their predictions are limited in so far as the future reflects the past and all relevant variables do not deviate from their expected paths. In other words, in the terminology of Alfred Marshall, economics is akin to the science of the tides, not the science of physics. Hence, Bernanke is perfectly clear to economists who, like myself, have the luxury to carefully and cautiously debate the future of the economy while leisurely quaffing a pint of exquisitely crafted ale.

Life on the trading room floor, however, is decidedly different. I understand – and correct me if I am wrong – that actual money is at stake. Moreover, while market participants are indeed concerned about the state of economic activity six months hence, they also need to place trades on the next FOMC meeting. They are willing to accept uncertainty regarding the former, but uncertainty concerning the latter is simply discomforting. And for many, the possibility that every FOMC meeting for the next six months may be “data dependent” is disturbing to say the least

You may choose to take the approach of former Treasury Paul O’Neil, and dismiss any notion that adequate communication with market participants is important. Price stability is the Fed’s job, not the happiness of traders staring at green screens. Call me a dreamer, but I prefer to believe that a certain symbiosis exists between monetary policymakers and the financial markets, and that that symbiosis is enhanced by clear communication of the Fed’s policy intentions.

Again, one could argue that the Fed is in fact being remarkably clear about their intentions:

The Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information.

What is lacking, however, from the Fed is clear direction of how incoming data will impact policymakers’ forecast. In other words, while we may know the Fed’s null hypothesis regarding the path of economic activity, market participants apparently lack sufficient underlying detail of the Fed’s model to determine the impact of incoming data on the Fed’s forecast.

For example, it is clear that Bernanke & Co. have deliberately changed their message. Changing the message can only reflect the intention to change the policy. And, as far as the next meeting is concerned, there are only three options on policy: Tighten, loosen, or do nothing. Given that loosen is out of the question, and tighten has been the policy to date, it is reasonable to believe that a change in language implies the intent to pause, at least at the next meeting.

The Fed has taken pains, however, to note that their decision is data dependent. A reasonable interpretation is that incoming data could shift the Fed’s opinion of a pause at the next meeting. And many market participants read the incoming data just that way. From Bloomberg:

"The market is basically questioning the Fed's ability to curtail" inflation, said Todd Clark, director of trading at Nollenberger Capital Partners, a brokerage firm in San Francisco. "It's very hard to contain it once it starts."

My problem is that the Fed has not changed its language despite incoming data suggesting that the inflation situation is not under control. Rising commodity prices and an unsettling CPI report have not elicited a change in rhetoric toward a more hawkish tone. In fact, the inclusion of the word “yet” in the statement, is another signal that the Fed is moving closer to a pause, not further (in this I agree with John Berry). The incoming data do not appear to be having an adverse impact on the Fed’s near term outlook.

What about the longer term outlook? While, we could surmise that the incoming data is raising the odds of an interest rate hike later in the year, but that doesn’t make much sense. Wouldn’t policy be better served, then, to hike at the next meeting rather than wait further? But the language is leading us to believe that the Fed wants to pause at the next meeting, isn’t it?

This is why the Fed has a communication problem. The way the data are rolling in does not appear to traders to be consistent with the Fed’s shift in language. The resolution to that conflict is that the Fed is not worried about current inflation, as nothing can be done to correct recent indicators. The Fed is focused instead on future inflation, and their models indicate that the economy will slow and that inflationary pressures will ease. But that still leaves us with the problem of not knowing how to interpret incoming data in light of that forecast.

Still, an attempt must be made. My attention remains drawn to the Fed’s outlook for growth:

The Committee sees growth as likely to moderate to a more sustainable pace, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy price

Combined with the impact of inflationary pressures to date:

As yet, the run-up in the prices of energy and other commodities appears to have had only a modest effect on core inflation, ongoing productivity gains have helped to hold the growth of unit labor costs in check, and inflation expectations remain contained.

The Fed is taking the position that worries about commodity prices and energy are overstated. For example, while the headline number on import prices is up in April, prices were flat excluding energy. This will reinforce the Fed’s contention that globalization and productivity forces are sufficient counterweights to inflationary pressures. Instead, the focus is on demand. And demand means primarily consumer demand, not investment demand. To this extent, the weak retail sales report – excluding gasoline – for April will support the Fed’s contention that the lagged impact of interest rates is working its way through the economy, as expected, dealing a blow to the household spending. Similarly, the Fed will note the weaker than expected consumer confidence figure.

On consumer confidence, I have some concerns about the following interpretation reported in the Wall Street Journal:

Economists attributed the decline to -- what else -- high energy prices. The drop reflects "the sudden surge in gas prices," said Ian Shepherdson, chief U.S. economist for High Frequency Economics. "If sentiment stays at this level -- it might even decline further -- you should expect a serious slowing in…consumption" in the second and third quarters, he said.

I don’t believe that weak sentiment leads to a reduction in consumer spending. Instead, I believe that an income constrained households cannot consume as much as they would like, and consequently are unhappy. Low consumer confidence reflects the unhappiness of households as they feel forced to reallocate spending away from non-energy goods.

In short, my interpretation of policy at this point is that the Fed intends to pause at the next meeting while awaiting data that calls into question their expectation of slowing demand later this year. In this light, they will discount nominal signals such as prices and focus on real indicators. Currently, real data on housing and consumer spending are consistent with their null hypothesis. Still, they will not give an all clear to the market with the economy bouncing along near potential. They will continue to hold an inflationary bias.

Assuming that the Fed does in fact take a pass at the next meeting, my bias is to expect the Fed to return to tightening later this year. My sense is that continuing steepening of the yield curve – the 10-year bond sits at 5.19% as I write – reflects a relatively strong global economy. I am not convinced that a slowdown in US consumer spending growth will significantly impact that strength; I tend to believe that substantial business cycle fluctuations are attributable to shifting investment patterns. Even if the consumer does slow, my current thinking is that the Fed will find it necessary to continue following the 10 year rate; otherwise, there will be a tendency to draw excessive resources from the future into the present. In this context, rising rates would not be considered “good” or “bad.” They simply are part and parcel of a realignment of global economic activity that will alter the constellation of interest rates, prices, and the exchange rate.

But, as always with my forecasts, it depends…..

What do you think, will the Fed pause at its next meeting? Should it pause?