Fed Watch: Set to Hold Steady

Tim Duy says based upon current data, the Fed is unlikely to change the target interest rate:

Set to Hold Steady, by Tim Duy: While I was swamped with work over the past two weeks, market participants as well as John Berry at Bloomberg, have done my work for me, increasingly pricing out a rate cut at the FOMC’s next outing. Incoming data have remained strong enough to keep Bernanke & Co. on the sidelines for the moment.

Last time I wrote, I concluded with:

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.

On average, incoming data, outside of housing, has signaled enough strength that the Fed can be more confident in their baseline forecast of moderate growth. To be sure, I wouldn’t exactly call the ISM report a “blowout,” although it did confirm that the immediate impact of the credit disruption on manufacturing activity was minimal. Perhaps more of a surprise was the strong showing on manufacturing reported by the New York Fed, but I am wary of putting too much weight on regional numbers as they can vary greatly from month to month. Still, it reveals that the nightmare scenario imagined by the bears remains in their heads.

More surprising was the jobs report, not the gain in nonfarm payrolls reported in September, but the sharp revision to the formerly negative read on August. That, coupled with a still stable level of initial unemployment claims, suggests a slowing of the labor market, in some cases reflecting specific industries, such as construction and retail trade, in some cases likely caution on the part of employers, but with enough underlying strength in the economy to avoid the mass layoffs typically seen in recessions.

Not that anyone really believes that a recession is underway, not at least during the third quarter. Incoming data on consumption and trade leave forecasters comfortable with a growth rate of around 3%, give or take. To be sure, it doesn’t feel like 3%, because a solid piece of that growth stems from an “improvement” in the trade deficit. I believe it is commonly forgotten that a portion of the slowdown in consumer spending, perhaps a big portion, is borne by overseas producers in the form of slower import growth. And stronger export growth simply means that we are producing stuff for other people to consume. Rebalancing will look good on paper, and is necessary, but I doubt will produce the warm, fuzzy feelings expected by the anti-trade group.

It is still tough to imagine that the Fed cut interest rates in a quarter that is likely to yield a solid growth number, right after a 3.8% quarter. In last night’s speech, Fed Chairman Ben Bernanke justified the Fed’s decision to cut interest rate as insuring against the possibility that Wall Street CEOs will not be able to make the payments on their yachts the troubles in financial markets would lead to a more general credit crunch:

This action was intended to help offset the tightening of credit conditions resulting from the financial turmoil. Risk-management considerations also played a role in the decision, given the possibility that the housing correction and tighter credit could presage a broader weakening in economic conditions that would be difficult to arrest. By doing more sooner, policy might be able to forestall some part of the potential adverse effects of the disruptions in financial markets.

What about the future path of policy?

One of the things I like about Bernanke is his ability to give clear guidance when needed. I find it somewhat comforting to return to a moderate take on the recent flow of data:

Since the September meeting, the incoming data have borne out the Committee's expectations of further weakening in the housing market, as sales have fallen further and new residential construction has continued to decline rapidly. The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year. However, it remains too early to assess the extent to which household and business spending will be affected by the weakness in housing and the tightening in credit conditions. We will be following indicators of household and business spending closely as we update our outlook for near-term growth. The evolution of employment and labor income also will bear watching, as gains in real income support consumer spending even if the weakness in house prices adversely affects homeowners' equity. The labor market has shown some signs of cooling, but these are quite tentative so far, and real income is still growing at a solid pace.

Housing is a downside risk, and without additional evidence that that the housing downturn is contributing to excess weakness in other parts of the economy, the Fed can take a pass in October. Is their any chance the Fed will start to think about reversing the September move? Not very likely. While the data might still signal moderate growth, the housing market creates too much downside uncertainty in the forecast. Moreover, it is too early to say that credit conditions have definitely returned to normal. Citibank and Friends are clearly still worried (see Nouriel Roubini’s commentary) and Calculated Risk notes that the ABX market may be set for another downturn. No, the Fed will not change course with the financial markets on edge.

Yes, I know that moderate growth coupled with a variety of warning signs on inflation make the case for a reversal, but the Fed simply could care less about your concerns:

On the inflation side, prices of crude oil and other commodities have increased somewhat in recent weeks, and the foreign exchange value of the dollar has weakened. However, overall, the limited data that we have received since the September FOMC meeting are consistent with continued moderate increases in consumer prices.

This is Fedspeak for “sell the Dollar, we don’t care.” Just kidding, sort of. The Fed will be watching for official inflation, core PCE inflation. They are not ready to respond to the falling Dollar or rising commodity prices; I believe they are more complacent on inflation than the obligatory “inflation risks” clause would lead you to believe, and perhaps rightly so…to date, inflation by their measures is not a problem, and while the steepening yield curve points to some worries among market participants, it does not suggest that inflation has gotten away from the Fed.

For my part, the global economic landscape continues to leave me a bit unsettled. Commodities have resumed their upward surge, with oil now above $86 and gold exceeding $760. The Baltic Dry Freight Index is rapidly moving to new highs. The Chinese stock market is going stratospheric. The IMF has written off the Dollar, although the G7 will most likely say something Dollar supportive this weekend. And, probably worst of all, I see a strong chance that all of these trends will build through the 2008 Olympics – all at the same time that credit market concerns keep the Fed in neutral with an easing bias.

For now, however, all is good. Be happy.

In short, solid incoming data erased fears of imminent economic destruction, as well as my expectation for a rate cut this month (watch the data turn against me again). Given the uncertainty in the housing and financial markets, the odds still favor additional rate cuts, but if the current pace of data is maintained, the Fed will be content to sit tight at 4.75%.