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Monday, October 01, 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 on Monday, October 1, 2007 at 12:24 AM in Budget Deficit, Fed Watch, Monetary Policy | Permalink  TrackBack (1)  Comments (27)

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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]

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