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Thursday, February 28, 2008

Fed Watch: This Train Doesn’t Stop

How will the Fed respond to recent evidence of heightened inflationary pressures and slower economic growth?

This Train Doesn’t Stop, by Tim Duy: Dual mandate, but one policy tool. A choice has to be made in the short run. Focus on inflation, and hold policy relatively tight? Or focus on growth, hoping that soft economic growth will tame inflationary pressures? The Fed continues to choose the latter path. In truth, at this point they have no other choice. It was unlikely that the Fed could bring a halt to this easing cycle as long as economic data point at recessionary conditions; this was always the danger of moving so quickly early in the cycle. And it became unthinkable to back away from the current set of policies after Congress followed up on Fed Chairman Ben Bernanke’s push for fiscal stimulus. The die is cast. Look for another 50bp in March and then two more 25bp cuts at subsequent meetings to bring the Fed Funds rate to 2%.

Bernanke’s Senate testimony left unchanged market expectations for additional easing. The overall tone was, as expected, in line with the dour assessment offered by Vice Chair Donald Kohn. The encouraging signs – low inventories, solid balance sheets in nonfinancial corporations, solid export growth – were few, while weakness was abundant. It read as an extended version of his February 14th testimony. That said, there are heightened inflation concerns. This sentence from February 14:

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.

Has evolved to:

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 in an environment of downside risks to growth, stressed financial conditions, and inflation pressures.

While not saying so outright, the new sentence implies stagflation. Not surprising, as incoming price data are difficult to ignore, and left the Fed revising upward their near term inflation expectations despite a downwardly revised growth outlook:

The central tendency of the projections for core PCE inflation in 2008, at 2.0 percent to 2.2 percent, was a bit higher than in our July report, largely because of some higher-than-expected recent readings on prices.

Still, the expectation is that inflation will moderate in the months ahead, allowing Bernanke to succinctly define the near term path of policy:

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. Although the FOMC participants' economic projections envision an improving economic picture, it is important to recognize that downside risks to growth remain. The FOMC will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks.

Insurance against downside risk + benign inflation outlook = more rate cuts. While interesting to dissect, the relevance of Bernanke’s testimony for near-term policy was something of a forgone conclusion. Consider this:

However, the recently enacted fiscal stimulus package should provide some support for household spending during the second half of this year and into next year.

I don’t think it should be forgotten that the stimulus package was arguably custom designed by Bernanke:

I agree that fiscal action could be helpful in principle, as fiscal and monetary stimulus together may provide broader support for the economy than monetary policy actions alone. But the design and implementation of the fiscal program are critically important…

To be useful, a fiscal stimulus package should be implemented quickly and structured so that its effects on aggregate spending are felt as much as possible within the next twelve months or so.

In other words, “DO IT NOW.” Congress and the President obliged, spilling red ink to get the checks in the mail in time for the summer driving season. If Bernanke fails to deliver additional rate cuts as expected, it will be perceived as a negative policy shock. I have got to imagine that Fed action to offset the fiscal stimulus that Bernanke supported would not go over well on Capitol Hill. The Senate would be inclined to crack open the Federal Reserve Act and make an omelet.

Not surprisingly, Bernanke’s inclination to continue pushing rates lower is resonating throughout financial markets. Inflationary pressures are building globally (note that China is completing the chain that leads to an inflationary spiral, setting the expectation that high inflation will be matched by higher wages), reflected in surging commodity prices and the freefall of the dollar. The former is weighing heavily on US consumers. Indeed, I am amazed that this story is only starting to capture the attention of the press. So much attention is placed on the housing market as the source of declining consumer confidence, but over the last three months, headline CPI has surged 6.8% annualized. Sure doesn’t look like nominal wages gains are keeping up. No wonder confidence is collapsing.

And I sense it’s going to get worse – the Fed’s policy stance is giving additional impetus to commodity prices as investors pile into the asset class as an inflation hedge and a response to the weaker dollar.  Moreover, low US risk free returns (a measly 2% on a 2 year Treasury) are forcing market participants to search out higher returns, and commodity prices look like a safe bet for the time being. The new asset bubble? Perhaps – but this one will have a primarily inflationary impact on the US economy. Moreover, it will weigh against the deflationary impact of the housing/credit market turmoil. Swamping it if the policy response is to continue propping up an unsustainable level of domestic demand. (I wonder when someone in Congress is going to realize that higher inflation is rapidly chipping away at the recent minimum wage hike?)

Not a pretty combination of events. And Bernanke knows it:

Upside risks to the inflation projection are also present, however, including the possibilities that energy and food prices do not flatten out or that the pass-through to core prices from higher commodity prices and from the weaker dollar may be greater than we anticipate. Indeed, the further increases in the prices of energy and other commodities in recent weeks, together with the latest data on consumer prices, suggest slightly greater upside risks to the projections of both overall and core inflation than we saw last month.

But the bottom line is that he can’t stop the rate-cutting train now. He can only hope that inflation expectations remain reasonably well anchored while his attention is focused on the deteriorating growth outlook. To pull this off, Bernanke will have to hope for minimal nominal wage growth. I don’t know if this will be a political feasible outcome after the period of real wage stagnation experienced during the Bush Administration.

Sidenote: CR found the silver lining to higher inflation – it will accelerate the housing correction in real terms.

    Posted by on Thursday, February 28, 2008 at 12:57 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (42)

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