Tim Duy reevaluates after today's surprise move by the Fed:
The Surprises Just Keep Coming, by Tim Duy: One thing is clear – after six months of struggling to learn the policy objectives of the Federal Reserve under Chairman Ben Bernanke, I just am not going to catch a break. Ironically, I sent the following email to Mark Thoma last night, after I saw his lead-in to my last piece:
Funny guy...but truthful. The Fed's been kicking my a** lately. Still can't believe I got December right.
If I listen to Mishkin and his "medium term" outlook, I just know I am going to get burned again.
And there it is. Sigh – some days I wish that Mark had not convinced me to start doing the Fed Watch thing again.
I was referring of course to Federal Reserve Governor Frederick Mishkin’s recent comments:
I think there is too much focus on what decision will be made about the federal funds rate target at the next FOMC meeting (Mishkin, 2007e). What is important for pricing most financial assets is the path of monetary policy, not the particular action taken at a single meeting. For these reasons, I hope the recent enhancements to the Federal Reserve’s communication strategy--especially the greater prominence of the macroeconomic projections of FOMC participants--will help shift attention toward our medium-term objectives and our approach in meeting these objectives.
I knew that Mishkin was throwing up a false signal, yet Fed policymakers just seem so sincere that they want to pursue greater transparency. Before I got lost in Miskin’s preamble, I had titled my last piece “Financial Freefall Put 75bp in Play.” Should have stuck with it.
Still, I am not so uncharitable as Wilhelm Butier and Felix Salmon, although I genuinely empathize with their frustration, both of whom express dismay over this “panic” move. Fundamentally, I tend more toward Jim Hamilton’s interpretation. But it was a panic move, no question about it. It stinks of the appearance of equity price targeting, and reeks of desperation - especially since each time the Fed cuts rates, they sent a message similar to that of the December 11 statement:
Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time.
Such statements, and the supporting speeches, have pulled me in almost every time. I focused too much on Bernanke’s moves toward greater transparency, while neglecting his work on credit markets and, as Paul Krugman reminds us, the experience of the Bank of Japan at the zero-interest rate bound. The transparency/long term forecast story is essentially meaningless in the current environment, and the failure of the Fed to drop references to their long term forecasts earlier is, in my opinion, the most significant failure in the Fed’s communication strategy. Indeed, the Fed stepped up those efforts by publishing their forecasts! Thankfully, the most recent Fed statement neglects to include such a forecast.
Still, I am surprised that Fed policymakers are surprised with the flow of current data – they clearly believe they are far behind the curve. What did they expect to see if growth rates were decelerating from the superheated pace of the 3rd quarter to something around 1%? The Fed’s own forecasts were bordering on near-recession territory in the near term. And did they honestly expect that the hundreds of billions of dollars that flowed out of housing would suddenly reappear in housing – or some other part of the US economy – within a few months of August’s meltdown?
But, here again, I missed something critical – Bernanke’s blasé attitude about global imbalances. From his September 11 speech:
First, these external imbalances are to a significant extent a market phenomenon and, in the case of the U.S. deficit, reflect the attractiveness of both the U.S. economy overall and the depth, liquidity, and legal safeguards associated with its capital markets…
Second, current account imbalances can help reduce tendencies toward recession, on the one hand, or overheating and inflation, on the other…
Third, although the U.S. current account deficit is certainly not sustainable at its current level, U.S. liabilities to foreigners are not, at this point, putting an exceptionally large burden on the American economy..
Bernanke appeared to dismiss, as late as September, the possibility of a sudden stop of capital inflows to the US. But that is in fact exactly what was happening in the mortgage market – a broad global pullback from the asset class sapped households of one source of financing. The imbalance did not “reduce the tendency toward recession” but instead increased it. I thought it was clear that foreign saving was supporting US consumption via the housing market. And I thought it was clear that US consumption would slow measurably as a result.
I still think that the Fed will have only minimal impact supporting the housing market – a bubble once broke cannot be recreated. The vast sums of money available with low underwriting standards simply are not coming back. And we don’t know where in the US economy they will show back up – or if in the US at all. Of course, lower rates will provide some supportive effect - eventually, rates will fall enough that those with equity in their homes and good credit ratings can get a refinancing boost. For some that is already happening (I am just 25bp away from making a call to the mortgage broker). Like fiscal stimulus efforts, lower rates soften the transition to a new growth path.
In any event, the Fed has consistently reacted more quickly than I believe implied by their forecasts. What does this mean for future policy? My argument from last week still stands – the Fed needs to continue cutting throughout this period of economic weakness, and now they can do so without playing lip service to their forecast. I can’t imagine they believe this week’s cut was in lieu of a cut next week as well. Indeed, given their clear concern over the state of equity markets, it seems prudent to bet that they will match market expectations of another 50bp cut (which begs the question – why not due 100bp today?). And assuming the economy remains near or at recession for the first half of the year, expect a minimum of another 75bp. That would bring us down to 2.25%. I had thought the Fed was hoping to anchor expectations to policy fluctuations – hence the whole point of the moves toward inflation targeting – but the policy see-saw continues. Perhaps it is the only policy that works in an asset-bubble driven world.