Tim Duy analyzes the arguments for and against further rate cuts:
It Will Only Get More Interesting, by Tim Duy: Six months ago, I doubt anyone would have believed that the Federal Reserve would be cutting interest rates 50bp during a quarter in which GDP posted 3.9% (albeit likely overstated) and another 25bp during a month in which nonfarm payrolls gained 166k. Yet here we are…can it really be a surprise that oil is nearing $100, gold is topping $800, and it takes more than 2 bucks to buy a British pound? One has to imagine that the Fed must be feeling a little uneasy about pulling the trigger on another 25bp last Wednesday given Friday’s employment report. Still, they likely take comfort in the belief that they drew a line in the sand with the statement, declaring a balanced risk outlook.
But can they stick to that line during a scary four months? Can they look through to that period of “moderate growth” that they keep predicting? I would like to believe they are ready to stick to their guns, but recent history is not on my side.
The October employment report and the 3Q07 GDP report have really only one interpretation – no matter how much you gnash your teeth at the data, or accuse government statisticians of laziness or incompetence, they simply reveal that the US economy has remained remarkable resilient to the housing downturn. This doesn’t mean that everything is coming up roses in the economy; far from it. No reasonable person believes the 3.9% figure accurately reflects the US economic environment, just as no one (except the bears) paid much attention to the 1Q07 GDP report. What this year’s GDP reports suggest to me is that the economy is likely growing at somewhere around a 2.75% rate, give or take, and that this quarter will be weak.
Likewise, the employment report shows weakness where expected; my attention is drawn to retail hiring in particular. This remains consistent with my view that consumer spending is softening – not collapsing – on the back of the housing downturn. Still, solid employment growth in other sectors continues to support household spending. Truth be told, I was surprised that commentators were looking at initial unemployment claims as a signal of a deteriorating labor market; claims have been trending in the same 300k-350k range for over a year. I don’t see much difference in recent weeks.
Moreover, some of the weakness in consumers is being offshored to foreign producers. This minimizes the impact of the housing downturn on the domestic economy – remember that the housing bubbled spurred a consumer led recover that was very different that the investment led boom of the tech bubble. The collapse of the housing bubble will have consumer spending as its primary channel, and I think the ultimate impact of will be less severe than the collapse of tech bubble. Flattening employment of relatively low salary retail jobs is a far cry form mass layoffs of hundreds of thousands relatively high salary tech workers.
Still, this is not meant to imply that the next few months will be an easy ride. It won’t be; I anticipate that the housing market will be washing out late this year and early next year, and the GDP numbers will likely hover around 1%. Last November my simple recession probability model based on the yield curve suggested that the November 2008 probability of recession would edge over 50%:
Interestingly, Menzie Chin notes that:
[Late addition: 9:45am] Highlighting the uncertainties looking forward several quarters, e-forecasting's October real time leading indicators measure now reads 52% probability of recession in the next six months...
Now, the probability of recession stays high through February 2008 before dropping off in March. Note that this is a prediction based on the steepening of the yield curve last spring. The yield curve continued to steepen, pushing the probability of recession in June 2008 to around 7%. Now, on the back of Fed easing, the odds of recession by next fall are negligible.
In other words, the steepening of yield curve was signaling that the softness in the economy would pass by the middle of next year – well before anyone was even thinking about a Fed rate cut. As an aside, has anyone noticed that the bears were screaming to pay attention to the yield curve last year, and have now all but forgotten it?
While it is just a simple model, it is consistent with two points. The first is that it supports the Fed’s contention that downside risks are currently high, but the medium term outlook is more positive. Second, that in the near term economic weakness will place the Fed under considerable pressure to cut rates further, especially given continuing fears of a credit crunch.
Can the Fed resist that pressure to keep cutting even if they are confident that the medium term risks are really balanced? If the “risk management” faction at the Fed continues to hold power, it seems like more rates cuts are likely, especially if there is any hint of further softening in employment or investment. That is what recent history tells us.
Standing in the way of additional cuts, however, is these new-found inflation concerns that appeared in the last statement. Declining core-inflation has been cited as a justification for Fed easing based upon decreasing estimates of the neutral Fed funds rate. I would only like to suggest that the recent history of core-PCE is not all that comforting. Looking a three-month inflation trends on an annualized basis:
I detect something of an upward trend in the past four months, on the order of 50bp – perhaps it is too early to be lowering estimates of the neutral rate? Personally, I wouldn’t break out the champagne on the inflation story just yet. It appears, however, that Fed Chairman Ben Bernanke and Governor Frederick Mishkin – the power couple in the “risk management” regime – already popped the cork.
Of course, I think most of us suspect that we are also exporting inflation to the rest of the world, especially those economies that unbelievably hold onto Dollar pegs at a point when it is clearly becoming unsustainable. Most of us, that is, that do not work on Constitution Ave. The Gulf states, already experiencing inflation pressures – over 10% in the U.A.E. – cut interest rates to match the Fed and prevent additional upward pressure on their currencies. I can’t see this helping the global inflation picture (I warned that the Fed might unleash a global wave of liquidity after the first 50bp). On the other side of the world, China’s actions to raise fuel prices are expected to ripple through the economy and boost already rising inflation. For more, Barry Ritholtz provides the recent inflation run down here.
It would appear, however, that few nations are willing to break their Dollar links before China does, which suggests that the US will be able to keep exporting a portion of its inflation abroad for the foreseeable future. But with inflation poking up its head all over the globe, one has to imagine that an end game is getter closer. We can only expect international currency tensions to intensify with the Fed running a policy at odds with most of the world. How many Treasuries and other US assets will the world be able to absorb when inflation is less a threat and more a reality in much of the globe? Of course, reducing these imbalances should be a long run goal – see Brad Delong’s recent thoughts – but the acceptance of some slowing of US domestic demand has to be part of the process. The Fed is walking a narrow line; too much “risk management” liquidity and US growth is at odds with the rebalancing scenario.
Where does all this leave me? I want to believe that the Fed will actually follow a policy consistent with the stated medium term growth outlook, but I have already been slapped down once on that call. The employment report, if repeated in next month, clearly calls for a pause at the next meeting. But if the threat of a credit crunch is sustained throughout an already weak quarter, the “risk management” coalition at the Fed may push through another rate cut in December. Given the recent turmoil in the financial markets, I tend to shade my expectations toward another cut – once bitten, twice shy.