Fed Watch: Headed For Another Game of Chicken?

What the Fed says is different from what financial markets expect. Here's Tim Duy:

Headed For Another Game of Chicken?, by Tim Duy: Over the last two weeks, Fedspeak has been undeniably hawkish.  Does anyone listen?  As near as I can tell, pretty much no one in the global financial markets is listening. Expectations for additional easing in the months ahead are only growing. What’s a Fed watcher to do? Listen to the Fed or the financial markets? The smart money is on the markets and suggests the best move is to continue to shade expectations toward another rate cut in December.

The hawk parade was kicked off when Federal Reserve Governor Frederic Mishkin stepped up to the podium to reinforce the recent FOMC statement – delivering a clear message that he sees growth and inflation risks as equally balanced, and that the data, not the markets, will drive the outcome of the December meeting. Mishkin’s remarks were clearly intended to reduce expectations that the Federal Reserve is driving an unstoppable rate cut train. More interestingly, he waived the inflation flag, suggesting that Fed officials are starting to worry that inflation expectations are fraying. In total, he wants us to believe that if the data stream remains consistent with recent patterns, the Fed will hold tight in December. He bolstered that warning with a reminder that the Fed can always take back what was given in the last two outings of the FOMC:

The FOMC perhaps could have waited for more clarity and left policy unchanged last week, but I believe that the potential costs of inaction outweighed the benefits, especially because, should the easing eventually appear to have been unnecessary, it could be removed.

Pretty much a clear message – don’t take another rate cut for granted. And the hawkish beat kept up through the week; a nice little compilation can be found in the WSJ Marketbeat blog. A particularly blunt statement came from Philadelphia Fed President Charles Plosser:

… in comments to the New York Times today, suggests that fourth quarter economic growth of 1% to 1.5% is already included in his forecasts, saying “the key here is growth would have to be less than the forecast to cut rates again.”

Later in the week, Fed Chairman Ben Bernanke offered his testimony, which many observers viewed as offering little, if anything new. I saw a couple of new things, notably the section on how recent data affects the outlook:

In the days since the October FOMC meeting, the few data releases that have become available have continued to suggest that the overall economy remained resilient in recent months. However, financial market volatility and strains have persisted.  Incoming information on the performance of mortgage-related assets has intensified investors' concerns about credit market developments and the implications of the downturn in the housing market for economic growth. In addition, further sharp increases in crude oil prices have put renewed upward pressure on inflation and may impose further restraint on economic activity…

Let’s break this down into three parts:

1. Economy remains resilient – argues for no cut in December.

2. Persistent financial pressure – argues for another rate cut.

3. Oil prices will certainly raise inflation, but only possibly cut into growth – combined argues for no cut.

On net, this suggests Bernanke is thinking of a pause in December. And if you didn’t get the message clear enough, Fed Governor Randall Krozner was downright blunt in his comments:

So, to sum up, the economy seems poised to grow for a while at a noticeably slower pace than it did during the summer, in part because of lower home sales, less residential construction, and generally smaller increases in consumer and business spending. A sequence of data releases consistent with the rough patch for economic activity that I expect in coming months would not, by themselves, suggest to me that the current stance of monetary policy is inappropriate.

Krozner is building on Plosser’s remarks – we expect bad data, you expect bad data, get over it and look further into 2008. Moreover, he goes a step further and argues for diminishing marginal benefits and increasing marginal costs to additional monetary policy: 

Looking forward, one feature of monetary policy to keep in mind is that, all else equal, each successive action in the same direction tends to lower the incremental benefits and to raise the incremental costs of additional actions. For example, unless underlying economic conditions or risks change substantially, reductions in the target federal funds rate tend to be associated with decreasing incremental benefits in terms of further mitigating tail risks and with increasing incremental costs in terms of the potential for inflation to increase.

Not only does he think another rate cut is unnecessary; in the current environment, it would only do more harm than good. 

Yet despite the steady stream of hawkish talk, the odds of a 25% rate cut in December exceed 80% according to futures prices at the CBOT. Summed up by the Wall Street Journal titled Rate Cuts Not Likely to Continue:

Despite a Fed statement accompanying the last rate cut and various speeches suggesting rates are on hold, futures markets are pricing in another quarter-point rate cut next month. Mr. Kroszner's speech had little impact on that pricing.

Financial market participants are staking out a position that appears completely at odds with the intentions of policymakers. The Fed’s repeated decisions to throw stated inflation worries overboard in the face of the ongoing mortgage/housing/credit market turmoil – even as they reiterate their medium term forecast – has engendered expectations they will continue to cut rates until market conditions normalize and the housing market clearly bottoms out. Neither one of those things is likely to happen before December 11.

In other words, the Fed’s inability to communicate the nuances of their “risk management” paradigm has cost them credibility with financial market participants. The Fed is saying they expect weak growth, it needs to be exceptionally weak to get us to cut. Market participants are saying “you cut rates when GDP growth was nearly 4% and the economy added 166k jobs. How could we possibly believe that you will pause when GDP growth is 1% and job growth is closer to 80k?”

I am hard pressed to see a pattern of data evolve between now and December 11 that would suggest growth is significantly lower than the 1-1.5% range the Fed appears to anticipate. There is just not that much data between now and then. Combine that outlook with the consistent Fed rhetoric almost explicitly saying they intend to pause and a “no cut” call should be a slam dunk. But market participants are effectively saying that ongoing credit turmoil argues for continued risk management cuts, and if the Fed doesn’t deliver, already fragile markets will become unglued. Thus, by this thinking, the Fed will have to deliver a cut. And that is a cut the Fed has been delivering since September – August if you include the surprise discount rate cut. 

The smart money has been to bet on the market. I simply am not confident that this Fed is willing hold off on a rate cut simply to establish credibility. If Fed officials want to shift expectations away from a rate cut, they need to stop talking about the “risk management” approach. Just give the forecast, stop giving reasons to ignore the forecast.

As an aside, if you are looking for political motivations for the Fed to keep cutting, doesn’t it seem like just a little too coincidental that on the day Krozner makes a clearly hawkish speech that Senator Dodd threatened to hold up Krozner’s Senate confirmation? Apparently, if Krozner wants to keep his job, he better be voting for a cut next month, regardless of his Friday speech?

Bottom Line:  Anyone taking Fed comments at face value can reasonably conclude that the intention of policymakers is to pause in December. I don’t know how you can get any more blunt than Krosner on this point. They are looking for data significantly at odds with their forecast to justify another cut, but there is not that much data coming in over the next few weeks. Yet I still shade my expectations toward another rate cut, as I can’t see the Fed willing to risk market stability to cement their credibility. It’s all risk management…