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Monday, September 10, 2007

Fed Watch: The Box Closes

Tim Duy says the Fed has painted itself into a corner:

The Box Closes, by Tim Duy: Last time I wrote, I concluded:

Tough times for a Fed watcher – knowing the Fed wants to hold steady, but seeing the box they made closing in around them. It is difficult to see what combination of data and events will allow the Fed to hold steady in the months ahead at this point. The best chance for the Fed to avoid a rate cut (a cut they don’t want) is that both the financial markets remain calm and the August jobs report is very strong.

As it turns out, the August jobs report was pretty much the opposite of strong. Normally, the Fed would wait for another jobs report to confirm the weakness; I think they will see this number by itself as an aberration. Just the day before, as the Wall Street Journal noted, policymakers were out in force with a seemingly choreographed message intended to dissipate expectations of a rate cut. After all, the Beige Book did seem to confirm their contention that the overall damage from recent financial turmoil was limited. And August retail sales are looking considerably better than expected. The ISM numbers held mostly solid. Indeed, the data had been cutting their way. This all, however, is now just dust in the wind.

The pressure to cut is enormous, too much so, I think, for the Fed to resist. Politically, the Fed erred with the August discount rate cut. It was a clear example of academics thinking they are cleverer than everyone else. That action, and the accompanying statement, only entrenched expectations for Fed funds rate cut. They should have known that. Now, given that the jobs report did not cut their way, in addition to pressure from Wall Street, the pressure from Capitol Hill is overwhelming. From Bloomberg:

''A strong response is required -- specifically, a meaningful interest-rate cut,'' Frank, chairman of the House Financial Services Committee, said in an e-mailed statement. ''The deeply troubling August employment report should end any debate about the action that the Federal Reserve Board must take when the Open Market Committee meets on Sept. 18.''

My thought is that for the purpose of maintaining central bank independence, better to look to be driven by the markets than by Congress. Too late for that.

I still believe the Fed will cut only grudgingly. I anticipate the next round of Fedspeak will not be supportive of those looking for 100+bp of easing in the upcoming months. I place better than even odds that we see a dissent this time around. I only expect 25bp. But what about the accompanying statement?  I am sympathetic to William Polley’s view that the Fed will not want to give the impression that another cut is a sure thing, preferring to leave a balanced statement of risks. That is my instinct as well, but I admit to being troubled by it; a balanced statement now I think will make the Fed look foolish after the events of the past weeks, and the fact that the August statement mentioned only downside risks to growth, and nothing about inflation. 

I doubt this will be the only rate cut in any event; we are entering a soft spot in economic activity, and data from the housing sector by itself will be sufficient to maintain expectations that we are all going to die. See the latest news from Countrywide for a sample. 

As far as the economic outlook, I believe one has to make a decision to live in today’s data or tomorrow’s data. Near term, I expect considerable weakness as the housing market washes out. But my year ahead forecast based on the yield curve is telling a pretty clear story; this Fall and Winter will be tough, but by Spring economic growth should rebound:


The math on this is straightforward; just look at the totality of the data.  Typically, the Fed does not initiate a rate cutting cycle on the back of a 4% GDP number. Typically, the Fed does not initiate a rate cut cycle with the ISM manufacturing index above 50 – we used to look for three consecutive sub-50 reads to guarantee a cut. Typically, the Fed does not initiate a rate cut cycle on the backside of an inventory correction. I know it may be tough to believe, but the Fed is not behind the curve; a cut now will actually put them in front of it compared to their usual timing. 

Note also that gold broke out above $700, copper bounced today, oil is poised to make a run for $80, the Baltic Dry Index is off the charts, productivity growth is falling, and the Dollar is set to make another drop.  Moreover, I suspect China will be revisiting their currency/foreign exchange reserve policies after the 2008 Olympics, adding to additional downward pressure on the Dollar. 

In short, I think the Fed is rightfully cautious about the inflation outlook, but policymakers are likely to cut rates anyway. Historians should take note; I have a sick feeling that this is the moment the tide turned on the 25+ year battle against inflation.

    Posted by on Monday, September 10, 2007 at 12:24 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (27)


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