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September 30, 2007

Fed Watch: The Fed's Next Move

Tim Duy is looking for clear signals about the Fed's next move and having trouble finding them:

The Fed's Next Move, by Tim Duy: Although the last FOMC statement did not commit the Fed to a policy direction, market participants expect Bernanke & Co. to keep cutting right through the New Year. With the stage set for the FOMC to increasingly discount inflation concerns as the housing market worsens, it is difficult to argue against that expectation. Of course, a labor report stands between us and the next meeting - but will it be enough to draw attention away from housing?

The case for additional rate cuts appears to revolve on the direction of housing and inflation at this point. Regarding the former, return to the most recent FOMC statement:

Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

Should we be concerned then about housing or financial conditions? What if housing continues to collapse in the months ahead despite loosening credit conditions? For now, I think it is best to assume that the Fed, or a majority of policymakers, is no longer confident it can disentangle housing from financial markets. Consequently, I expect that housing activity will play a significant role in the Fed's forecast.

And that view of the economy is dismal, to say the least. I won't go into the details of recent housing data, leaving that to others such as Jim Hamilton and Calculated Risk. The upshot is that the situation continues to deteriorate, and it is likely that we are only seeing the beginning of significant price declines. Moreover, Fed rate cuts are highly unlikely to offer any support to housing; at best, the Fed can soften the impact of a declining housing market. Bubbles cannot be recreated. Like all bubbles, this one was based on the expectation that housing prices always rise. With that delusion shredded, the speculators are in the wind.

Regarding inflation, the official numbers are cutting in the Fed’s direction. Friday's report on PCE is really cut and dry. Core-PCE posted three consecutive 0.1% gains, pulling the 3-month annualized rate to just 1.5% and the year-over-year rate to 1.8%. True, core-CPI is running at a 2.5% rate over the past 3 months, but, until we hear differently, the Fed prefers the PCE measure.

Housing down, inflation down. Given the Fed's recent behavior, case closed. More rate cuts are coming.

What could then forestall those rate cuts?

Presumably stronger than anticipated growth, but that presumes that the data between now and October 30/31 is read at face value and not pre-turmoil, and I think that is a big presumption. For example, the case for housing bleeding into the broader economy is based on a significant wealth effect that drives consumer spending into the ground. In contrast, look at the strong showing of the consumer in August, with real personal consumption expenditures up 0.6% for month. Even if consumption is flat in September, the quarterly gain will be 3.2% annualized. 3.2% is nothing to sneeze at.

But, as I said, this is pre-turmoil, so my expectation is that the Fed will discount the figure. Can the same be said for initial unemployment claims? Claims have trended downward since the 50bp rate cut, suggesting that the fears of a broad labor market deterioration that arose after the August read on nonfarm payrolls are overstated. That said, if the concern is the impact of the housing market, then that impact will only be felt in the future, and thus so will the employment impact. Thus, there is a risk that any rebound in September's employment report would be discounted; I suspect that it would take a strong report, over 150k gain, to offset the housing uncertainty.

You get the idea; if the Fed is focused on the housing-consumer-credit market story, the continuing downtrend in housing, and the uncertainty it creates in the forecast, appears sufficient by itself to justify additional rate cuts, especially with inflation sliding.

But is the inflation outlook really all that pretty? Aren't we supposed to be worried about future inflation, not past inflation? And what about those hawkish comments from bank presidents? From Bloomberg:

Poole followed other Fed bank presidents in suggesting that additional interest rate cuts aren't a foregone conclusion. Federal Reserve Bank of Atlanta President Dennis Lockhart said today he had an ''open mind.'' Earlier this week, Philadelphia Fed President Charles Plosser warned that the Fed's Sept. 18 rate cut risks accelerating inflation, and Dallas Fed President Richard Fisher said rates could be lowered or raised as needed.

I so want to pay attention, but my current temptation is to toss out hawkish commentary by bank presidents as essentially out of touch with the Board. This comment on these four is likely right on the money:

''They all have basically zeroed in on the financial market dimension of this rather than the housing spillover dimension,'' said Michael Feroli, a JPMorgan Chase & Co. economist in New York who used to work at the Fed. ''There definitely is a faction, and they are a minority, but they are not trivial.''

Maybe not trivial, but I have already been fooled once on this front, and, in any event, inflation warnings are simply nonsensical after a 50bp cut. Indeed, given the steepening of the yield curve, the fire sale on the Greenback, and the surge in commodity prices, clearly market participants are not giving much weight to such inflation babble.

And if you are worried about future inflation, you likely focus on just those things - oil, gold, Dollar, etc. The Fed, however, looks ready to downplay each and every one of these inflation indicators. On oil, from Fed Governor Frederic Mishkin's March 23 speech:

My view--that recent changes in inflation dynamics result primarily from better-anchored inflation expectations and not from structural change or simply the achievement of a persistent low rate of inflation--implies some very good news: Potentially inflationary shocks, like a sharp rise in energy prices, are less likely to spill over into expected and actual core inflation. Therefore, the Fed does not have to respond as aggressively as would be necessary if inflation expectations were unanchored, as they were during the Great Inflation era.

On exchange rates, from the same speech:

In contrast, unpublished empirical work by the staff at the Federal Reserve Board suggests that, once we take the rising share of imports into account, the influence of import prices on core inflation in the United States has not changed much in the context of reduced-form forecasting models.6 At the same time, the influence of exchange rate movements on import prices--the so-called pass-through effect--may have fallen substantially, at least according to some studies.7 If so, then the influence of exchange rate fluctuations on domestic inflation may now be less than it once was, when one controls for changes in the volume of our foreign trade.

Both of which imply that at least, Mishkin, and I suspect much of the Board, is significantly less worried about the Dollar, commodity prices, Chinese inflation, etc. than the inflation pessimists.

For my part, I am concerned that the Fed appears to have written off the dollar. My concern stems from rising international tensions - the Fed is dumping additional liquidity into the system at a time when most central banks are attempting to turn off the faucet. The Fed is implicitly, if not explicitly, relying on countries with fixed exchange rates to absorb that additional liquidity at the cost of inflation in those economies. Moreover, those economies with floating rates become the anti-Dollar bets, forcing the Euro area, Canada, the UK, etc, to be the deflationary counterweights to the inflationary US policy.

Is it a surprise that the ECB is under pressure to support the Euro with a rate cut? The only surprise is that there is not more chatter about an ECB intervention if only to erase the idea buying the Euro is a one way bet.

In my darker moments, I fear that the Fed is forcing their foreign counterparts down one of two paths - either central banks with appreciating currencies throw in the towel and match Fed rate cuts, thereby unleashing a fresh wave of global liquidity, or central banks with fixed exchange rate finally decide that they can no longer bear the inflationary cost of supporting the US current account deficit.

Adding to my concerns is that the Fed is overestimating the downside risk to the economy. Certainly, the past correlation between housing downturns and recessions is nothing to ignore. But too many indicators are not consistent with a recession for me to be embrace a dark outlook. Why are initial unemployment claims flat? Why does the consumer appear to have momentum in the 3Q07? Why are readings on manufacturing activity not solidly on the decline? Why did the inventory to sales ratio slide back to its lows? Why does the Baltic Dry Index continue to reach new highs? Why isn't faltering demand undercutting support for oil prices?

Bottom Line: The housing down / inflation down data flow gives the Fed room to continue cutting on the basis of forecast uncertainty. Presumably, strong data would undermine the case for additional cuts, leaving me wary of blow out ISM and employment reports. There is a risk that the Fed did intend the September move to be a "one and done" action, but unless they want to get into the habit of surprising financial markets, they need to make that clear - or the data need to be strong enough to do it for them.

Agree or disagree, Tim would appreciate your comments.

    Posted by Mark Thoma on September 30, 2007 at 07:29 PM in Budget Deficit, Fed Watch, Monetary Policy 

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    Tim Duy, economics professor at the University of Oregon, posts from time to time on Mark Thoma's blog, Economist's View, and Fed watching is one of his favorite topics. His latest, "The Fed's Next Move," is particularly thorough and cogent. He goes... [Read More]

    Tracked on October 01, 2007 at 12:15 AM


    Comments

    dissent says...
    In my darker moments, I fear that the Fed is forcing their foreign counterparts down one of two paths - either central banks with appreciating currencies throw in the towel and match Fed rate cuts, thereby unleashing a fresh wave of global liquidity, or central banks with fixed exchange rate finally decide that they can no longer bear the inflationary cost of supporting the US current account deficit.

    Okay, the first one qualifies as dark moment material: no more 'fresh liquidity waves' please. But the second? Sounds good to me. It has to happen anyway.

    We have a Federal Reserve because we have a national economy. The dollar has to decline anyway. The Fed is putting the national economy first and facilitating a dollar decline. And the problem is?

    Posted by: dissent | September 30, 2007 at 08:28 PM

    calmo says...

    So much here that I like:

    "..in any event, inflation warnings are simply nonsensical after a 50bp cut."
    "...clearly market participants are not giving much weight to such [the Fed minority] inflation babble."

    "The Fed, however, looks ready to downplay each and every one of these [oil, gold, Dollar] inflation indicators."

    "For my part, I am concerned that the Fed appears to have written off the dollar."

    "Moreover, those economies with floating rates become the anti-Dollar bets, forcing the Euro area, Canada, the UK, etc, to be the deflationary counterweights to the inflationary US policy."


    I even like this:
    There is a risk that the Fed did intend the September move to be a "one and done" action, but unless they want to get into the habit of surprising financial markets, they need to make that clear - or the data need to be strong enough to do it for them. [Isn't the Fed smitten now with this "data dependent" outlook...making that "one and done" obsolete?]
    although I can't help smiling about the prospect of cultivating a habit of being surprised or surprising others.
    It B a mystery to me now what the Fed expected with the 50bp cut. At the outset I believed it was intended to jolt those long term rates down...to ease the pain for those resets. [You see how easily I can be misled...] And if the mortgage rates did show signs of dropping, they might continue with those cuts. But the mortgage rate rescue is...somewhat hampered...and time is running out. [So imagine them pulling a Fisher and adding 50bp. Exactly. So bring out the ax again --to show that you not only still mean business but that you were earnest to begin with too.]
    Ok, wazat a vote for another 50bp from Tim?
    I cannot imagine anything less than the 2nd coming that would prevent the Fed from continuing this medicine as the housing led economy falters.

    Posted by: calmo | September 30, 2007 at 08:34 PM

    Robert Edele says...

    Continued easing (which the Fed is likely to do) is certainly not the correct recipe. As it is inflation is spiraling upwards and kicking the dollar while it's down will hurt, and hurt big time.



    With confidence in the dollar dropping and real interest rates falling deep into negative territory as inflation rises, the dollar will feel any abuse very strongly.



    That some confidence in the dollar remains is the main factor that separates the USD from Zimbabwe's currency.



    Negative real interest rates are not natural and encourage people to buy anything to avoid losing money to inflation. If the money supply is held constant, the interest rates will quickly rise because of a lack of lenders, but in the current system of fixed rates and a floating money supply, the money supply will instead explode causing runaway inflation as interest rates turn even more negative. Central banks can try to hold back the flood with some short term success, but they will eventually drag their own countries down with the USD if they try too hard. China in particular is suffering from rapidly escalating inflation driven in part by buying so many USD.

    Posted by: Robert Edele | September 30, 2007 at 09:39 PM

    dissent says...
    China in particular is suffering from rapidly escalating inflation driven in part by buying so many USD.

    Boohoo, China has to buy dollars in order to maintain their peg and scoop up any American manufacturing job that isn't bolted to the ground.

    Boohoo, China has inflation because it has to buy dollars to maintain their peg and scoop up any American manufacturing job that isn't bolted to the ground.

    Boohoo, China has a stockmarket bubble because it has inflation because it has to buy dollars to maintain...

    BOOHOO AMERICAN COMPANIES WHO PUT ALL THEIR EGGIES IN THE CHINESE BASKET!

    Posted by: dissent | September 30, 2007 at 10:00 PM

    archer says...

    I may be wrong, but I think the reason that you haven't yet seen the strong signs of a weakening economy is 1) faulty stats and 2) some sectors are running on fumes. Recall that the job creation figures of the last three months were written way down with the last report (although people watching them at the time commented on dubious birth/death adjustments that implausibly showed a lot of growth in construction).

    I have a lot of trouble with our employment stats. They don't correspond with the reality I see (and I live in one of the most robust sub-economies, New York City). I know of tons of people who are either "consulting" or "retired" who are actually unemployed but would much rather be working. Participation in the employment questionnaires is lousy and has gotten worse over the years. And our labor participation rate among males 25-45 is worse than in France. But we claim to have much lower unemployment than they do.

    Similarly, our GDP figures are tainted by hedonic adjustments.

    To see what is really going on in the economy, you probably need to look at hard proxies, like cardboard boxes, electricity usage, etc. That is more trustworthy than the official releases.

    Posted by: archer | September 30, 2007 at 10:37 PM

    athreya says...

    The Fed cut by 50 bps in September because it didn't want to do a 25 and then be dragged by the market to do another one. Secondly, having consistently underestimated the housing bust, Fed had to move in to contain further damage from the credit freeze. I think Mishkin's paper at Jackson Hole provides the rationale. On inflation, again going by Mishkin, Fed's soft target is 2% on core PCE, not the 1-2% that hawks (eg: Poole) keep mentioning. So there is no inconsistency in Fed cutting rates now that core PCE is trending just below 2%. Finally, I agree that the claims data has thrown a wrench into the slowdown/recession argument. I keep thinking that the extent of residential construction retrenchment is yet to show up in jobs data. Wonder whether we get another head fake in next 1-2 readings before the bad news starts trickling in. Net net, I expect more cuts, another 50-75 bps in the next 4 meetings.

    Posted by: athreya | October 01, 2007 at 12:36 AM

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