More Fed Volatility

Tim Duy interprets the latest signals from the Fed:

More Fed Volatility, by Tim Duy: The truth is, I am finding tracking the Fed to be maddening. And Fed Chairman Ben Bernanke’s testimony and comments yesterday – or at least the market reaction – is no exception to that rule. There is so much in his testimony that reminds of stories I told back in April. For instance, according to the Wall Street Journal:

He [Bernanke] told the panel the Fed "can't do anything about" the current month's inflation rate: "we have to be looking at the forecast."

On April 28, I wrote:

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.

At the time, I was preparing for a pause in tightening in June. Then, like now, it looked as if Bernanke was dismissing a worrisome reading on inflation. But I was slapped down hard on that call in the wake of hawkish language that signaled the FOMC’s intention to hike rates in June. Do I want to go down that road again? Or did I get the motivation right, but the timing wrong? Like I said, maddening.

Getting back to square one, I found Bernanke’s testimony yesterday to be remarkably consistent with the last FOMC statement and my interpretation of how the Fed likely views the data. I suspect he put great effort in creating a statement that lacked the appearance of flip-flopping. The economy is slowing, especially when compared to the heated pace of the first quarter. The slowing is mostly concentrated in consumer spending, while investment spending holds strong. With regard to the slowing, the full impact of previous rate hikes has yet to be felt. With the economy anticipated to slow to potential, inflation pressures are expected to ease as well. The balance of risks remains titled toward inflationary conditions, but the timing of any additional moves is dependent upon incoming data.

If the testimony was indeed consistent with last FOMC statement, why did markets surge yesterday? My interpretation of events is that market participants, like myself, were mentally geared for a more hawkish Ben, and instead the Gentle Ben of the last FOMC statement sauntered up to the stage. The higher than expected reading on core CPI released earlier in the day only enhanced this fear that Bernake would turn hawkish.

My concern is that, although the Bernanke sounded soothing relative to expectations, the incoming data argue for another rate hike in August. Indeed, while Bernanke was sanguine about the growth outlook, he explicitly warned of the risk of inflation:

More generally, if the pattern of elevated readings on inflation is more protracted or more intense than is currently expected, this higher level of inflation could become embedded in the public's inflation expectations and in price-setting behavior. Persistently higher inflation would erode the performance of the real economy and would be costly to reverse. The Federal Reserve must take account of these risks in making its policy decisions.

Note the term “persistently higher inflation.” And then note four consecutive months of 0.3% gains in core CPI. And note that inflation was broad based in May; as David Altig notes, you can’t blame it all on owner’s equivalent rent. Could Bernanke really be so dismissive of such a report as to want to signal a pause?

My opinion is that he was not trying to signal a pause – he is clearly not using his speeches like his predecessor Alan Greenspan as a signal of the Fed’s intentions. As Greg Ip described in the Wall Street Journal:

In a significant break from Fed commentary of the past few years, he gave no explicit signal about how the Fed would move interest rates to achieve that forecast, forcing markets to decide for themselves.

Bernanke’s approach appears to be that he lays down the facts as he sees them, and leaves it to us to interpret the data accordingly. And the fact is that the economy is slowing. But the fact also is that inflation readings remain elevated. Moreover, I can easily imagine a scenario where growth is slowing, at least as measured by domestic demand, but inflationary pressures remain a concern because headline GDP is holding near trend. There are encouraging signs that exports are accelerating, while the domestic slowdown will likely temper import growth. If this story holds (essentially the global rebalancing story), then the external sector will add positively to GDP. In other words, in order to reduce the trade deficit, we will likely have to accept a period of relatively weak domestic demand growth. Graphically:

Note the period in the latter half of the 1980s, when the trade deficit was shrinking back to balance. Presumably, the preference is for domestic consumption to be compressed rather than domestic investment. Such an outcome is feasible; firms will need to maintain production to provide for external demand and import substitution, but households will feel miserable due to low rates of consumption growth. The Fed will see the issue of who bears that pain, high or low income groups, as a fiscal problem (Presumably, fiscal authorities could raise taxes on high income groups to lessen the need of monetary policy to pull all the weight. Yes, I managed to say that with a straight face. Barely.)

Given the push and the pull between readings on inflation and growth, I think the market is getting the story basically right, although participants may have been too dismissive of the CPI report in the wage of Bernanke’s testimony. The odds stand in favor of another rate hike in August, or, if a pause, then another hike in future months. Considering low unit labor costs and slowing growth, the Fed will likely not want to go much further without evidence of faster than expected growth or persistent inflation. Plenty of data to watch between now and August 8.

Note: The FOMC minutes from the last meeting were released today. Tim is giving a final right now for a summer class, but plans to do an update later if there is anything in the minutes that changes the outlook given above.

Here's the update:

Update: The FOMC minutes are a reminder that although evidence of economic slowing is evident, inflation concerns leave FOMC members uneasy. This suggests that yesterday’s CPI report will not be met with complacency on Constitution Ave. Some key points:

Nonetheless, participants noted a risk that the drop-back in inflation could be slower or more limited than the Committee would find desirable since resource utilization was currently tight and the pickup in price increases had been broadly based rather than being limited to a few specific sectors that could be linked to energy costs.

And, although economic slowing is expected to ease inflation pressures,

…several factors were cited as potentially sustaining upward pressure on inflation, and the range of participants' forecasts for core inflation in 2007 rose by 1/4 percentage point relative to the range of forecasts made in February. Some participants noted that businesses in their Districts were experiencing difficulty hiring certain types of skilled workers, suggesting that increased wage pressures might emerge. In addition, some business contacts indicated a greater ability to pass higher costs on to customers, although other businesses continued to report that their pricing power remained limited. The relatively taut resource markets and the lagged effects of the increase in energy prices raised the possibility that inflation could continue at somewhat elevated levels for some time. Higher levels of inflation, should they persist, could become embedded in inflation expectations.

Remember, four consecutive 0.3% readings on core CPI will sound to some FOMC members as pretty persistent. Moreover, oil prices remain uncooperative at a minimum. Also see Greg Ip’s “Fed Reality Check,” where he notes:

That said, the fact there has been no break in the tightening cycle in spite of all the hints to the contrary serves as a useful reminder that no matter what the Fed says, or what we think it says, circumstances change, and the Fed must act accordingly.

Bottom line: Bernanke’s testimony should not be viewed as a guarantee of a pause; the data remain the focus at the FOMC. A pause doesn’t mean done.