Tim Duy says the Fed is looking for some level land where they can pitch a tent, rest up for awhile, and assess the economic geography before setting out again in one direction or another:
Fed Set to Cut Again, But Looking For a Chance to Pause, by Tim Duy: Reading Fed Chairman Ben Bernanke’s testimony, I couldn’t help but be drawn to the following:
A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of monetary policy is properly calibrated to foster our mandated objectives of maximum employment and price stability and, in particular, whether the policy actions taken thus far are having their intended effects. Monetary policy works with a lag. Therefore, our policy stance must be determined in light of the medium-term forecast for real activity and inflation, as well as the risks to that forecast. At present, my baseline outlook involves a period of sluggish growth, followed by a somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus begin to be felt. At the same time, overall consumer price inflation should moderate from its recent rates, and the public's longer-term inflation expectations should remain reasonably well anchored.
The forecast, my nemesis, back again and with perhaps the clearest message we have seen that the Fed is looking for an endgame sooner than later. Most importantly is the reminder that policy works only with a lag – if there is to be a recession, it will be regardless of what the Fed does at the March meeting. Today’s policy impacts next year’s data.
To be sure, Bernanke left the door open to additional cuts, but he wants to reassert control over expectations. He wants market participants to conform their expectations to the medium run forecast, a failed effort to date as each near-term forecast was rendered obsolete within days of utterance. With this speech, Bernanke clearly lays out a rather dire near term scenario, including direct references to the widening credit crunch and stagnant consumer spending. All of which suggest he incorporates a considerable amount of negative news into his forecast. Which further suggests that he actually believes the line from the last Fed statement:
Today’s policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity.
I want to believe. Really, I do. Especially after Chicago Fed President Charles Evans mirrored Bernanke closely, including:
At 3 percent, the current federal funds rate is relatively accommodative and should support stronger growth. Indeed, because monetary policy works with a lag, the effects of last fall's rate cuts are probably just being felt, while the cumulative declines should do more to promote growth as we move through the year.
It actually sounds after if he would like to sit at 3% for awhile. And I think you can read the same into Bernanke’s testimony.
And yet still all this Fedspeak does little to sway me from my expectation that the Fed will cut rates another 50bp in March, and had minimal impact on market expectations as well. Fed policymakers lost credibility long ago; Bernanke’s testimony at best simply lays the foundation to rebuild the credibility in the months ahead. It is simply difficult to see how the Fed halts its easing campaign when faced with a steady stream of lackluster data at best. This has always been the danger of the Fed’s aggressive front loading of policy. Even more so now that political pressure is on, with three Fed nominees blocked by the Senate. And a special award should go to the Wall Street Journal’s Sudeep Reddy, who I believe is the first to write a “Bernanke’s days may be numbered” piece, complete with the requisite list of potential candidates for the Fed’s top job. The pressure is on, and the Fed has only one tool.
Rather than a pause now, I find it easier to see an end to end this cycle at a Fed Funds rate of 2%. Another 100bp can be broken in 50-25-25 increments, which keeps Bernanke’s foot on the gas into the summer, by which time I expect that the impact of past policy will begin to be felt. Indeed the bond market appears to be sensing this as well; from Across the Curve:
Some of the curve flattening represents prudent traders booking profits because no one has ever been fired for doing that. Banks, mortgage servicers and hedge funds were all busy unwinding steepening trades today. In addition, I did pick up the first faint rumblings of traders alluding to some terminal funds rate at the end of the process. Conversations with participants leads me to the conclusion that many expect that the Federal Funds rate will probably reach the 2.00 percent level and then the FOMC will enter cease, desist, and assess mode.
If 2% is the right target, then the 2 year bond is looking a little pricey. Moreover, reflect on the yield curve’s essentially sustained steepness despite the recent stream of less than reassuring economic data, suggesting that a lot of bad news is already priced into the markets. At least we can hope so.
Of course, this outlook assumes the Fed will have an impact on economic activity. And, of course, there will be those that argue the Fed is impotent, such as Paul Krugman here and Bloomberg here. Indeed, even Fed officials appear to be less than confident themselves:
''The increase in credit spreads has sort of worked against our policy,'' San Francisco Fed President Janet Yellen told reporters at her bank yesterday. ''The fact that the spreads went up so dramatically really resulted in an effective tightening of financial conditions that our cuts were partly meant to address.''
Not exactly credibility enhancing – “we didn’t understand what was going on, and we are powerless to do anything about it anyway.” In my mind, these criticisms fail to acknowledge the appropriate benchmark – it is only failed policy if you believe that the outcome would have been would be the same without the policy. I don’t – I think the carnage in the financial markets would have been much worse had the Fed not acted.
Also, the Fed can’t stop the credit crunch; they are probably doing the best the can. The US has lived beyond its means for decades, and the party was going to stop sooner or later – see Paul Krugman here. Moreover, there is more than one channel by which monetary policy impacts economic activity. As I have said before, by running a monetary policy that is out of sync with virtually every other economy on the planet, Bernanke is leveraging the willingness of foreign central banks to accumulate dollar denominated assets to support US fiscal stimulus. Someone has to buy the fresh flow of debt from Washington, and it won’t be savings constrained US households. And apparently, foreign central banks are willing to absorb endless amounts of US assets.
Or are they? Indeed, all the housing market doom and gloomers are missing the big story – how Bernanke is actually fueling a housing boom! Trouble is, the boom is in Hong Kong. From the Wall Street Journal:
…because two weeks ago and half a world away, the U.S. Federal Reserve cut interest rates again, hoping to stimulate an economy dragged down by a housing sector in disarray. Since Hong Kong pegs its dollar to the U.S. currency, it followed the Fed's lead, knocking the city's base rate down twice in less than two weeks for a total of 1.25 percentage points.
The unintended result: home-loan rates so cheap that they are throwing more fuel on an already scalding property market.
A typical mortgage here -- which is pegged to the prime rate which, in turn, is tied to the base rate -- now carries interest of about 3.1%. But compared with Hong Kong's inflation rate of about 3.8%, which is hovering at a more-than-nine-year high, that looks especially inviting, creating a so-called negative real interest rate.
The rest of the world can only absorb dollar denominated assets until inflation in the rest of the world becomes unsustainable. And the last thing that US policymakers need is for foreign central bankers to cease being the buyers of last resort for US debt. Which leaves domestic policymakers in a rather unfortunate position – they need to provide enough stimulus to lean against the credit crunch and soften the transition to a new and likely lower growth path, but not so much that they bite the hands that feed them. What is the tipping point? We don’t know, but in addition to the Fed, Congress looks set to seek the boundaries – the checks are not even in the mail, and Democrats are looking for a second stimulus package. And, if we emerge on the other side of this downturn with a lackluster economic environment characterized by a severely weakened consumer, expect another. And another. It is easy to talk about lower expectations for sustainable growth than to actually live with the reality of slower growth. I hate to sound pessimistic, but I anticipate rivers of red ink in the future – especially if a return to the Clinton-era employment to population ratio is the ultimate goal of future policymakers.
Bottom Line: It is difficult to pull away from expectations of another 50bp in March, although it looks like that Bernanke would like to do just that. 2% looks like a reasonable bottom at this point. Low US interest rates will resonate across the globe as central banks work overtime to absorb US debt – it should not be a surprise that commodity prices have failed to roll over as one might have expected given dire predictions for a global recession.