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Monday, September 18, 2006

Fed Watch: Another Recession Call

Tim Duy with a Fed Watch in anticipation of the upcoming FOMC meeting:

Another Recession Call, by Tim Duy: No, not mine. And not Nouriel Roubini's, whose call for a recession in 2007 is exceedingly well documented. Morgan Stanley' chief Asia economist Andy Xie is also looking for recession, but thinking more toward 2008, according to Bloomberg:

"We're headed for stagflation because the bond market believes the Fed," Xie said in an interview today on the sidelines of the International Monetary Fund annual meeting in Singapore. "Recession will happen when the bond market sees through the Fed and sells off. People will have nowhere to borrow money anymore."

…He says that inflation will persist because of rising prices in Asia, whose growth will fuel the global expansion next year.

"Inflation is not going away at all," said Xie. "It's coming from land prices in Asia, and that's feeding into production costs."

I tend to be cautious with "the bond market" is being fooled argument. Still, the Fed was supposedly done after Katrina, and we see how that story worked out. While Roubini expects that the housing slowdown will bring the US economy to its knees, Xie appears to feel that global growth will cushion the blow temporarily while a complacent Fed ignores global inflationary pressures. The Bloomberg article notes that pundit-land is getting increasingly dreary:

Morgan Stanley's New York-based chief economist, Stephen Roach, said that while he didn't share Xie's view, the "odds of a U.S.-led global recession are rising in the 2007-08 period and cannot be taken lightly." David Rosenberg, chief North America economist at Merrill Lynch & Co., forecasts a 45 percent risk of a U.S. recession next year.

One can't swing a dead cat with hitting a gloomy analyst lately. While few analysts are ready to predict a recession for next year, virtually all are hedging their bets in that direction. Market participants made up their minds long ago on what this meant for monetary policy; expectations of additional rate hikes have dwindled to negligible levels. Fed officials, however, have not embraced the gloominess that currently runs amok, leaving a bias toward additional tightening firmly in place. Fed officials just aren't buying the "end is coming" stories, and are instead still peddling the soft-landing scenario. For instance, Bloomberg also reports on Kansas City Fed President Thomas Hoenig's comments on Friday:

Federal Reserve Bank of Kansas City President Thomas Hoenig said today he expects the U.S. economy to grow near or "slightly below" its sustainable pace through the end of next year, helping to ease consumer-price inflation.

"That would be healthy and that would allow inflation to continue to moderate over the course of the outlook," said Hoenig, who is a non-voting member this year of the interest-rate setting Federal Open Market Committee.

Sounds consistent with San Francisco Fed President Janet Yellen's Sept. 12 speech:

Recent data suggest that the needed slowdown is indeed underway. After hitting a rapid 5½ percent pace in the first quarter, real GDP growth slowed in the second quarter to a rate of just under 3 percent. In looking ahead to the rest of the year, I see factors working both to support economic activity and to restrain it somewhat. Taken together, these lead me to expect that we'll probably see growth that is healthy, but somewhat below the rate that is sustainable in the long run.

Of course, the future is not without risks, including the most cited boogeyman, the housing market. According Yellen:

While it's likely that the slowdown in the housing sector will have only moderating effects on economic activity and will continue to unfold in an orderly way, I should note that we can't ignore the risk that a more unpleasant scenario might develop.

This might be just lip service, as Yellen doesn't appear to be losing much sleep on this subject:

While I doubt that we'll see anything like a "popping of the bubble"—in part because I'm not convinced there is a bubble, at least on a national level—it is a risk we have to watch out for.

What about her home state of California?

So Fed officials look optimistic on the growth forecast. Regarding inflation, the "warnings" reported by the press don't sound quite so worrisome read in context. From her final paragraph:

The bottom line is this. With inflation too high, policy must have a bias toward further firming. However, our past actions have already put a lot of firming in the pipeline. With the lags in policy we haven't yet seen the full effect of our past actions. These will unfold gradually over time. By pausing, we allowed ourselves more time to observe the data and more time to gauge how much, if any, additional firming is needed to pursue our dual mandate.

Likewise, Hoenig is not ready to give the all clear on inflation:

Hoenig said today's government report showing the pace of consumer-price increases fell in August was "good news" though "not as favorable as some would like."

In short, policymaker's are expecting a healthy slowdown will tame the inflation beast and, with clear signs of activity slowing, the Fed doesn't have to keep raising rates until the inflation numbers roll over. But, given that they see a moderate slowing, not a deep dive below trend, the bias toward additional firming will remain in place until the inflation numbers do roll over. Considering the current rates on 10 year Treasuries, the Fed simply is more concerned about the inflation outlook than market participants.

(On inflation, see also the rays of hope David Altig sees in the August median CPI data.)

Are Fed officials just clueless? Don't they see that the end is coming? I think not – I bet Fed officials are not working overtime to spin a negative story out of every number (see William Polley on spinning the retail sales figures and Jim Hamilton's broader look at recent numbers). Instead, they will tend to view the incoming data as largely consistent with their views of how the slowdown would unfold. Yes, activity is slowing, but Fed officials are not ready to make the leap between "slowing" and "recession."

But, understandably, so, so many others want to make that leap. The economy is at an inflection point, which raises the risk that an unforeseen shock will pull it from it moorings. Moreover, the Fed's record of actually managing a soft landing is dubious, with the episode in the mid-90's being the only real success story. But a significant disconnect between the seemingly complacent Fed and the gloomy analysts is the potential impact of the housing market reversal. Fed officials are genuinely not overly concerned with the housing-induced recession risk. It could be that they simply do not want to incite panic, but I don't think so. As Mark Thoma reminds us, Fed staff keep pumping out "it is all about fundamentals" research. And there is the view that the slowdown in residential construction will be offset by increase nonresidential construction (Calculated Risk reports on St. Louis President William Poole's thoughts on this). Moreover, I doubt they believe Roubini's story on the importance of the housing for job growth.

Note also that Greg Ip takes up the "Fed-market" disconnect theme in today's Wall Street Journal, noting also that policymakers remain concerned about inflation, may see a lower level of potential growth than generally believed, and, again, are less concerned about housing. I concur – without evidence of a more significant downturn in activity, the Fed will dismiss the building recession fears and hold policy firm, steady rates coupled with an inflationary bias. If you forced the Fed to choose between cutting rates and hiking rates, they would choose the latter. Luckily, they can choose to pause as well.

    Posted by on Monday, September 18, 2006 at 12:14 PM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (49)


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