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Thursday, February 07, 2008

Fed Watch: Fear Not Plosser

Tim Duy assesses the Fed's next moves in light of recent speeches by members of the FOMC and new data on the state of the economy:

Fear Not Plosser, by Tim Duy: Philadelphia Fed President Charles Plosser delivered a sobering speech today, including a reference to the 1970’s:

Unfortunately, I expect little progress to be made in reducing core inflation this year or next, and I am skeptical that slower economic growth will help. All you have to do is recall the 1970s when we experienced both high unemployment and high inflation to appreciate that slow economic growth and lower inflation do not necessarily go hand in hand. …

The speech threw cold water on today’s nascent equity rally, but was consistent with my expectations that Fed officials may try to reestablish some control over expectations. It did little to change my expectations: That the Fed will ease 50bp in March remains a safe bet. Plosser should be largely ignored, at least as far as the near term path of policy is concerned.

It is difficult to take Plosser’s warning seriously in the wake of the ISM service sector report. True, like its manufacturing counterpart, the prices paid index was less than comforting. But let’s just say that you believe that inflation is a problem, and likely to continue to be a problem. Fine – I think you can make a reasonable argument in that direction. But do you believe that the Fed Board shares your concern? Beyond, of course, the usual lip service about monitoring “inflation expectations?” Do you believe that, in the face of economic weakness, the Fed will be able to stand pat? Considering the direction and pace of recent policy, I see little reason to expect that Plosser’s warnings will be sufficient to forestall additional easing.

Consider also Senator Dodd’s meeting today with Fed Chairman Ben Bernanke, in which Dodd reached a certain understanding:

''The chairman is committed to using the tools available,'' said Dodd, a Connecticut Democrat. ''It's been evidenced already, and I'm confident he'll continue.''

Giving Bernanke the benefit of the doubt, he likely didn’t commit to additional easing. But Dodd is certainly leveraging market expectations to set the path toward additional easing. Also note that Dodd is holding up three Fed governor nominees, including the current Governor Randall Krozner. Senator Reid is also drawing a line in the sand on nominees. Indeed, I am surprised that we currently hear so little commentary about the possible erosion of Fed independence (although, arguably the Fed opened the door to such erosion when it abdicated regulatory responsibilities).

And note the Plosser’s message contained a “no recession” forecast. Considering that the ISM services number is a significant signal that a recession began in January, he may already be well behind the curve. Moreover, Bloomberg is reporting that the labor market is significantly worse than recent data would believe, as the exodus of the self-employed from the labor force (or, at a minimum, a significant reduction in their hours worked) is not accurately captured in the establishment data or initial unemployment claims. Yet another little twist from the nature of this downturn, as it hits an industry in which roughly 1 out of 6 workers is self-employed.

While Plosser might be off base with regard to near term policy, his longer term worries will appeal to inflation pessimists. There are a number of parallels with the 1970s, including a commodity price boom and slowing productivity growth. That, coupled with declining labor force growth, sets that stage for a substantial decrease in potential growth. Overall, I doubt very much that Americans will be happy with those rates of growth after the 1990’s boom, and there will be policy resistance. For example, note the difference between the Fed’s and the White House’s estimate of potential growth. Sure, 0.4 percentage points might not sound like much, but such policy mismatch can lead to a slow but steady increase in inflation over time. Moreover, note that this does not account for the weaker domestic demand growth necessary to adjust US consumption to production, or, in other words, eliminate the current account deficit. Lower domestic consumption growth will almost certainly meet with voter dissatisfaction.

In the near term, however, the inflation story will remain a risk second to the imperative of sustaining growth. Inflation is a potential story for 2009, at least as far as Fed policy is concerned. Indeed, the more bearish are moving in the direction of deflation predictions. And the government will soon be pulling out all the stops to boost spending power, via additional monetary easing and fiscal stimulus, to prevent any such outcome. I expect these forces to come into play gradually through the year, offsetting any real risk of deflation. Central bankers are far too willing to push liquidity into the system, and US banks are actively seeking funds from abroad to recapitalize (opposite of the behavior of Japanese banks in the 1990s), the combination of which will have a positive impact.

Adding to the current excitement is the often overlooked international dimension. There is clearly a growing concern about the weakness of the dollar, particularly against the European and Canadian currencies. From the WSJ:

"We don't want the euro to have to bear the brunt of currency adjustments by itself," German Deputy Finance Minister Thomas Mirow told reporters yesterday. A senior Canadian official complained this week about the spillover effects of the falling U.S. dollar, while French Finance Minister Christine Lagarde said last month that the euro is "a very strong currency" that disadvantages French companies.

Of course, the issue here is how are Europe and Canada aiding the US adjustment in the wake of the mortgage market collapse. There are two choices. The first is to accept the depreciation of the dollar and, and with it, recognize the Fed’s efforts at inflating the US economy are coming via a deflationary impact in the counterpart economy. The weak dollar stimulates an adjustment via an improvement in the US current account. Alternatively, a nation can fight the depreciation of the US dollar by purchasing US assets and thus supporting (or maybe simply preventing) the US adjustment by sustaining those capital inflows that support the US current account deficit. See Brad Setser for recent evidence on these approaches.

The European Central Bank, and, to a lesser extent, the Bank of England, choose the first approach, while China, oil exporting nations, and anyone else holding a dollar peg choose the second. Europeans are growing unhappy with this approach, and the expectation is that the ECB and BOE will have to relent, which has limited the Greenback’s fall in recent weeks, and redirect some fixed income flows back to the US by cutting rates. The ECB will be unhappy if forced down this road, especially considering their credibility on inflation fighting is being called into question. Alternatively, the ECB could just join the party and accumulate US assets and sterilize the monetary stimulus on the other side. Given the anticipated explosion in US fiscal red ink, there will be plenty of Treasury bonds to go around.

Note the growing calls to recognize the fundamental US problems as that of an emerging market undergoing a currency crisis. See for example Kenneth Rogoff and Ricardo Hausmann.

In other words, things are a complete mess. The housing bubble adjustment is not simply domestic in nature. The excessive consumption driven by the bubble was being supported by a steady stream of capital inflows, the mortgage-related portion of which dried up. To offset the adjustment, the Fed is cutting rates aggressively, driving down the Dollar in some cases and in others forcing foreign central banks to purchase Dollars, reducing the external imbalance on one hand and supporting it on the other. US fiscal policy will soon be attempting to offset the adjustment as well, flooding the markets with additional paper. And if the first round fails to hold, expect another. This stimulus will be hitting the US economy with an uncertain impact just as the potential growth rate appears to be decelerating. Through it all, US policymakers across the board appear to believe that the rest of the world will accept this state of affairs indefinitely. And as long as the rest of the world does, I imagine we can keep the party going.

Bottom Line: I anticipate the Fed will be forced into additional rate cuts, with a total of another 100bp a reasonable bet. The Fed left itself little choice but to drive rates down to ultra-low levels by cutting rates so aggressively before confirmation of recession. This is forcing the rest of the world to deliver substantial stimulus as well, with the ECB perhaps the next domino to fall. I do not believe this stimulus will be ineffectual. But I do not look for a pleasant economic environment on the other side.

I believe I underestimated the willingness of US policymakers to resist the adjustment necessary to bring internal demand in line with internal production. I suspect they will remain unwilling to change course unless significant signs of inflation arise.  On the other hand, if growth rebounds sooner than anticipated, the John Berry scenario, the Fed may tighten as quickly as it eased. I assign a low probability to this scenario.

I sound downright dismal tonight; information overload, perhaps, as I try to pull all these pieces together.

    Posted by on Thursday, February 7, 2008 at 12:59 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (15)

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