Tim's email says he is "a bit contrarian" in this one. Agree or disagree, I'm sure he'd like to hear you reactions:
Tim Duy: Fed Still Looking Through the Slowdown – Should You?: The spate of weak data has been well covered in a variety of places. David Altig presents some unsettling history, Jim Hamilton shares the rational concern over the path of core capital goods orders, with Menzie Chen following up on the implications of the 4Q06 GDP revisions, and Nouriel Roubini sticking to the hard-landing story. A pretty grim look at the data; indeed, the durable goods numbers have unsettled my sleep of late. (Interestingly, I would have expected a much worse ISM number given the read on durable goods. We just are not seeing the strong below-50 plunge consistent with a recession. Yet.)
Still, while acknowledging the downside risks to economic activity, Fed Chairman Ben Bernanke threw cold water on the idea that a rate cut was imminent in his most recent Senate testimony. The Fed continues to stick with its call of moderate economic growth (note that “moderate” appears to be around 2%, which suggests, as I have commented before, a not small lowering of potential GDP estimates) combined with easing inflationary pressures, with the possibility of greater than anticipated inflation still the predominant risk to that outlook. I admit to being sympathetic to that view, partly in response to the yield curve, partly on the mixed nature of the data.
But isn’t that yield curve still inverted? Yes and no. Something interesting happened recently. If you focus on the spread between the ten year and fed funds rates rates, you might have missed it. I tend to focus on the ten-two spread, which has been signaling a period of relatively soft growth and an enhanced risk of recession. I keep an eye on a simple probit model that uses this month’s spread to provide an estimate of the probability of recession in 12 months. Note that is not the probability of recession within the next 12 months. It makes a difference to me whether the recession is next quarter or four quarters from now. Also, I stick with a rolling forecast, not fitted values. The model predicted a period of substantial weakness beginning early 2007, with a 52% probability of recession in November of this year:
Through the past year, the ten-two spread has never been deep enough to signal much of a conviction that a recession is a foregone conclusion. The deepest inversion recently was 15bp in November. In contrast, March 2000 – exactly 12 months prior to the NBER dated recession – saw a 27bp inversion that grew to 41bp in April.
Interestingly, the ten-two spread steepened in March in the wake of not insignificant market volatility. My initial interpretation was that market participants saw a Fed rate cut as a foregone conclusion at that point. But throughout March, that expected rate cut was pushed further into the summer, and conviction about the cut has waned. Yet, last Friday, the spread stood at a positive 6bp, which yields a roughly 20% chance of a recession in March 2008 (I will recalculate when the Fed posts the March average for rates). In other words, if the steepness in the ten-two spread holds, it is signaling that economic weakness will be mild, short-lived, and largely dissipated by the first or second quarter of next year.
Alternatively, my initial interpretation that a rate cut was seen as a sure thing may be flawed. It may be that a rate cut is not necessary to stave off a recession. Instead, market participants were just waiting to take out the last remaining chance that the next Fed move would be a rate hike (although it was tough to see a hike in the imminent wake of the problems in the subprime market).
Another alternative is that while the bears are having a field day with some recent data, market participants have their eyes on the rebound in commodities such as metals and oil. Moreover, notice the sharp gains in the Baltic Dry Freight Index – not exactly a signal of impending recession. And while we get another read on the labor market this Friday, the fact that initial unemployment claims stubbornly hover around the 300k mark suggest that the status quo remains in place. Also, despite expectations for a collapse in consumer spending, the February PCE report revealed that real consumption growth is on track for a 3.3% gain in Q1 (I admit to being surprised on the consumption front, as I have been looking for growth in the 2-3% range). Maybe the March number will turn that around; we did see weakness in consumer confidence.
Bottom Line: Much of the recent data are weak, no doubt about it. Growth has slowed, plain and simple. And any optimism I see in the yield curve could be dissipated with Friday’s labor report. Or, as another Fed watcher once put it, it could be a case of Stockholm Syndrome, in which following the Fed forces you to think like them. But in any event, Bernanke & Co. are sticking to their guns, still looking through the downturn and downplaying the risk of recession. With so many ready to call the Fed wrong, it is worth thinking about the possibility that they are right.