Tim Duy says if you hear hawks screeching, pay them no mind:
Ignore the Hawks, by Tim Duy: Ignoring hawkish Fedspeak has been the winning strategy in recent weeks as increased market turmoil pointed to another rate cut this month despite repeated warnings from Fed officials. Clear statements that economic weakness is expected in the near term are dust in the wind compared to widening credit spreads. The debate is shifting towards a 50bp cut – a cut that cannot be ruled out given growing risk aversion in financial markets.
As recently as early last week Philadelphia Fed Charles Plosser reminded investors to ignore weak data:
In my view, if the FOMC members already expected some bad economic numbers and had already taken those into account in their outlooks when they set the fed funds rate target, then you should only see policymakers take action when the outlook changes significantly – not when a few pieces of bad economic news are released.
I doubt that Plosser was happy with the October rate cut, and I suspect he was less than thrilled when Fed Governor Donald Kohn came to the podium and gave the all clear for a rate cut in two weeks:
However, the increased turbulence of recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October. Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses. Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses a well.
Kohn is quite clear – ignore Plosser. While recent data may be as expected, the downside risks are once again on the rise and threaten to disrupt our benign forecast. This point was reiterated the next day by Fed Chairman Ben Bernanke, cementing the importance of recent credit market tightening in the upcoming FOMC decision.
Amazingly, Plosser did not take the hint, saying the following day that:
''I'll reserve my judgment until I get more information'' on whether risks have shifted, Plosser told reporters in Philadelphia today. The Fed will ''watch and see and react as appropriate.''
And more amazingly:
Plosser said of Bernanke: ''You may be sure of what he thinks. I'm less sure of what he thinks.''
Plosser will be a voting member in 2008 – it should get interesting if he doesn’t spend a little more time thinking about what Bernanke thinks. Plosser also floated the idea of cutting the discount rate, possibly to shift expectations away from a target rate cut:
Plosser noted that the Fed ''could'' further reduce the gap between the main rate and the charge on direct loans to banks. Officials in August lowered the discount rate by half a point, bringing the gap to 0.5 percentage point. The discount rate is now 5 percent, and the federal funds rate target is 4.5 percent.
''It certainly would be something that one could entertain,'' Plosser said about further reducing the spread between the rates.
To give Plosser the benefit of the doubt, these quotes may have been taken out of context, but one has to wonder if Plosser is reading any speeches other than his own given that Kohn already threw cold water on this approach:
In that regard, I think we had some success, at least for a time. But the usefulness of the discount window as a source of liquidity has been limited in part by banks' fears that their borrowing might be mistaken for accessing emergency loans for troubled institutions. This "stigma" problem is not peculiar to the United States, and central banks, including the Federal Reserve, need to give some thought to how all their liquidity facilities can remain effective when financial markets are under stress.
No Charles, the discount rate is simply a side show at the next meeting – market participants have wisely shifted the discussion toward a bigger fish, a 50bp cut. Deterioration in credit spreads is approaching the level that prompted a 50bp cut in September. And in some ways may be even worse. As noted by Jim Hamilton, risk aversion is spreading beyond commercial paper to Baa rated corporate bonds.
Still, I suspect the Fed will be hesitant to come to the table with a 50bp cut. Even the doves think they have already frontloaded policy. And the hawks will be foaming at the mouth as they likely believed that the balanced statement of risks implied a pause in December, and actually want to see hard data that changes their outlook before cutting again. I think that it would have been easier to justify a 50bp cut in December if they had passed on Halloween, but that ship has sailed.
Also, there are likely some lingering inflation fears on the FOMC. Note the three month trend in core-PCE:
Three-Month Annualized Percentage Change in Core PCE
While the year over year trends are comforting, the recent behavior of inflation is less so. Of course, given Bernanke’s focus on the credit situation, a recent uptick in inflation (a lagging indicator) is not going to forestall a rate cut, but it may give some pause before a 50bp cut, especially given the recent jump in headline inflation.
Bottom Line: The rate cutting continues, the Fed’s benign medium term outlook notwithstanding.