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Friday, July 20, 2007

Tim Duy: Fall Turbulence Ahead?

Tim Duy has his latest Fed Watch:

Fall Turbulence Ahead?, by Tom Duy: I admit that I have found Fed watching a bit tedious since Bernanke & Co. settled into a steady path last year. Caroline Baum summarizes the situation succinctly:

Dissecting the Fed's post-meeting statements in the hope of finding signs of a shift to a more neutral stance has been fruitless. Despite a word change here or there or a shift in emphasis, the Fed remains firmly in the camp that the risks lie with the failure of inflation to moderate.

I doubt, however, that the situation is quite as dire as Baum suggests:

Fed watchers, a cottage industry for whom real transparency under Fed chief Ben Bernanke has meant greater obsolescence…

I hesitate to believe Bernanke’s transparency is the driving force behind this supposed “obsolescence.” Instead, it is the stubborn unwillingness of the US economy to break under the weight of the latest shock, whatever it may be. The mix of growth and inflation suggested that steady policy is appropriate, and the Fed has followed suit. Still, for almost two years, since Hurricane Katrina, we have been going through the same dance – the US economy experiences a shock, a warning call is raised demanding a rate cut, the Fed, looking through the shock, fails to oblige, economic activity does not collapse, market participants reevaluate and move back to the Fed. An example from the minutes:

Market participants had largely anticipated the FOMC's decision at its May meeting to leave the target federal funds rate unchanged, but some market participants were reportedly surprised by the retention of the assessment that inflation was “somewhat elevated.” The publication of the minutes of the May meeting elicited little market response. Over the intermeeting period, however, investors seemed to reappraise their beliefs that the economic expansion would slow and that monetary policy easing would be forthcoming.  This reappraisal seemed to be based in part on the release of some economic data in the United States and abroad that were more favorable than expected.  As a result, the expected path of the federal funds rate over the coming year was marked up sharply in financial markets.

The role of the Fed watcher has been to call each of these bluffs. Are we on the verge of another divergence between the Fed and market participants? On the surface, it appears that the Fed and financial markets are largely in sync, with the odds overwhelmingly favoring the stability of policy throughout the fall. Recent Fedspeak has remained consistent with the outlook. Although the Fed has downgraded somewhat growth projections for later this year, which combined with encouraging signs of inflation, prompted Fed officials to declare the economy “more balanced” in the latest minutes, the message from Bernanke in this week’s Congressional testimony remained steady: 

With the level of resource utilization relatively high and with a sustained moderation in inflation pressures yet to be convincingly demonstrated, the FOMC has consistently stated that upside risks to inflation are its predominant policy concern.

The steady, continued deterioration of housing, and its related impact on financial markets, however, is once again producing calls for a Fed rate cut sooner than later. Notably, Brad DeLong is quite direct on the subject:

Certainly it's time for the Federal Reserve to make noises about how minimizing foreclosures and evictions is a good strategy for financial institutions to adopt. And if I were on the FOMC I would start voting to cut interest rates.

Jim Hamilton at Econbrowser is sympathetic to DeLong:

All of which leaves the Fed no alternative but to keep the target fed funds rate steady for now. But I share DeLong's big worries, and suspect that Bernanke must to some degree as well.

Hamilton suggests, however, that Bernanke is unable to act on whatever concerns her may have:

But I think Bernanke is unlikely to follow DeLong's advice, because the Fed Chair is in the same box he's been in all along-- fears about rising inflation.

The inflation story would not prevent the Fed from cutting rates if officials truly believed that the subprime problems will widen into broad tightening of credit conditions, a credit crunch. The deflationary implications of a credit crunch are obvious, and the Fed would quickly feed such information into its inflation forecast. Instead, the Fed is essentially telling us that a revaluation of risk in financial portfolios does not automatically imply that a credit crunch is under way. Indeed, Bernanke is telling the opposite story:

Even after their recent rise, however, credit spreads remain near the low end of their historical ranges, and financing activity in the bond and business loan markets has remained fairly brisk.

And he is not alone; from the Wall Street Journal’s economics blog:

The current turmoil in credit markets isn’t yet disturbing the financial system as a whole, a key Federal Reserve policy maker said Wednesday.

…Mr. Warsh said, “Thus far, however, the repricing of credit risk doesn’t appear to have imposed significant strains on the financial system.”

…Federal Reserve Bank of Philadelphia President Charles Plosser, in a speech in London Wednesday, was more circumspect. “Recently a hedge fund suffered large losses from positions it took in the subprime market, and there is concern that this could lead to large spillover effects to other hedge funds or to mainstream lenders to such funds,” he said. “How severe such effects will turn out to be remains to be seen. The coming months should provide a better indication of the magnitude of any adverse effects from this sector.”

The Fed does not sense DeLong’s immediacy on this issue, markets have not frozen, and hence a full blown credit crunch is considered by policymakers to be a rather low probability event and it has little impact on near term policy. “Wait and see” is a hallmark of Fed decision making.

None of this is meant to imply, however, that the risks to the US economy are not real. I think it likely that financial market participants will again question the stability of policy in the fall.  My simple model of recession probabilities based on the 10-2 spread has lately been pretty reliable in recent months.  The latest chart:

Duy71907

These are twelve month ahead rolling forecasts. The model predicted early 2006 that 1Q07 would flirt with recession, following by a rebound in 2Q07. Sounds good so far. That rebound, however, was predicted to be short-lived, with weakness reasserting itself by the end of the year and into 2008. But looking ahead into mid-2008, the recent steepening in the yield curve is pointing to a rebound once again.

Just a simple model, but it is consistent with three issues at the forefront of my mind:

1. The magnitude of the reacceleration of economic activity in Q2 is as much of a head fake as the magnitude of weakening in Q1 that prompted the some analysts to declare that a hard landing had arrived. I anticipate some pullback in Q3.

2. I agree that the housing market has yet to bottom. I expect that the next leg down will happen in the fall as it will take several months for delinquencies to turn into foreclosures.

3. I think the consumer is likely to remain soft later this year in line with deteriorating conditions in the housing market. “Soft” is not “collapse.”

While this sounds bearish, note that timing and magnitude are key. The steepening of the yield curve suggests that the broader markets are anticipating any slowdown in the fall/winter (the final throes of the housing slowdown?) will be temporary. Will the Fed see it this way as well? Given their recent propensity to look through weak spots in the economy, that would be the safe bet at this point, especially if once again the labor market holds up through the slowdown. In any event, there will be ample opportunity to once again question the path of policy.

    Posted by on Friday, July 20, 2007 at 12:12 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (3)

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