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Monday, March 10, 2008

Fed Watch: Set to Accede to the Market?

What will the Fed do at its next rate setting meeting? Will it cut the target rate by 75bps, 50bps, 25bps, or will there be no cut at all?:

Set to Accede to the Market?, by Tim Duy: Since last September, Bernanke & Co. have consistently sent the signal that more is better, and that whatever financial markets want, financial markets get. Now, in the wake of the February employment report, financial markets are looking for a 75bp cut on March 18. The Fed has been unwilling to deliver negative shocks to fragile financial markets, which argues in favor of the larger cut. Still, I can’t see this as the rational move by the Fed; at this pace, the Fed will find itself at less than 1% before any recent policy begins to impact the data.  Moreover, FOMC hawks would have to be force fed an even bigger cut than the 50bp I suspect they are barely able to choke down as it is. They need to draw the line at some point; otherwise, the Fed should just cut to the chase and slash rate to 1% next week.

As I have argued repeatedly, the Fed’s aggressive rate cutting has put them in a very tight policy spot. The strategy was that aggressive policy, along with the TAF, would bring a rapid recovery to struggling financial markets.  This strategy clearly did not work as expected.  Unfortunately for the Fed, this was not a run-of-the-mill financial panic. This is not simply a crisis of confidence.  The entire financial system was leveraged backwards and forwards on the basis of one simple idea: US housing prices only go up. With that idea proven illusionary, the financial system needs to deleverage to a point consistent with a very different risk profile.  This is simply far beyond what the Fed can manage with the tools it has available.

Now the Fed needs to find a point for a contemplative pause, as lower interest rates will only impact the economy with a lag. Today’s policy affects economic activity next year, and cannot undo the February jobs report. But the Fed cannot stop cutting rates outright; it is politically impossible to do so when job losses are mounting. And the Fed has engendered such aggressive expectations in the financial markets that even slowing the pace of cuts to 25bp increments will be effectively a negative policy shock. So the Fed is stuck between too much disappointment with 25bp or too much stimulus with 75bp.  50bp seems like the least worst path at this point.

What a tangled web…

One could argue that 25bp, or nothing, is the best response given ongoing inflation pressures. But on that front, the Fed will find a silver lining in recent jobs numbers. Ample evidence of labor market softness will strengthen the Fed’s conviction that wage pressures will continue to moderate in the months ahead.  That is, of course, unless currently high inflation pushes workers sufficiently against the wall that they have little recourse but to demand higher wages. Or enough workers exit the labor force due to low wages (I have got to imagine that the incentive to work at Wal-Mart for $7.00/hour – made lower in real terms by accelerating inflation – is pretty minimal) that employers are compelled to provide wage increases. Still, those are stories for another day; for now the Fed can take comfort that the American worker has been sufficiently coddled to accept declining real wages with a smile. Again.

Of course, regardless of the jobs report, the Fed was already bending over backwards to dispel inflationary concerns. For example, consider the inflation signal from commodities.  Fed officials are pretty clear that they do not believe that rising commodity prices are sustainable or have anything to do with low interest rates. Indeed, Fed officials are very careful to avoid linking rising commodity prices to their policy stance. To do so would create a bit of an inconvenient issue; in the last decade, an easy policy stance supported asset bubbles in equities and houses, two prices that conveniently do not reveal themselves directly in consumer price inflation. Supporting an asset bubble that feeds directly into the inflation process is a whole different story, one that FOMC members are not ready to read. James Hamilton, however, is willing to tell the story, and challenges FOMC members to prove him wrong by surprising the market with a 25bp cut next week.  Clever challenge, but one the Fed won’t take.

The Fed, of course, can’t afford to be proven wrong on their assertion that commodity prices are a side-event. If they admitted that commodity prices were inflationary, and that those inflationary pressures were driven by Fed policy, they would engender expectations of greater inflation and/or a cessation in rate cutting.  Either would be drive up longer term rates, undermining their efforts to alleviate the credit crunch. 

Fed officials are also careful not to link the declining value of the Dollar to commodity prices. This link should be obvious, as commodities are so often Dollar denominated.  But listen to Vice Chairman Donald Kohn’s take on commodity prices:

Disentangling the various global forces influencing commodity prices can be useful in assessing the implications of those prices for domestic output and inflation, and hence monetary policy. For example, it matters whether a rise in oil prices results from demand factors, such as stronger global real activity, or supply factors, such as a hurricane that shuts down production. For an oil-importing country, a demand-driven price increase would have less negative implications for domestic real activity than a supply-driven increase because an expanding world economy would help boost demand for the country's exports. For the United States, however, a rise in oil prices driven by stronger real Chinese activity would not necessarily lead U.S. export volumes to rise substantially, given the low propensity of China to import from the United States….

Because monetary policy has a limited ability to counter short-term price surprises, the distinction between transitory and persistent influences on inflation from oil and other factors is critical. If we were to project a continued significant rise in energy prices over the medium run, we would need to factor that expectation into the outlook for overall inflation. Doing so could have important implications for the stance of monetary policy--all the more so if we expected rising energy costs to lead to higher inflation expectations and elevated wage gains.

Still, a leveling out in oil prices seems the more likely scenario…

A willingness to admit the inflationary consequences of higher oil prices, yes.  But no willingness to admit that Fed policy might have just a little to do with those high prices. And certainly no discussion of how the denomination of that commodity in Dollars affect its pricing when those Dollars are rapidly falling in value.  And make no mistake – Fed policy is not simply one of benign neglect of the Greenback.  It is open season on the Dollar.  Supporting the Dollar would suppose some policy coordination among central banks, and Kohn makes clear his feeling on that topic:

Successful coordination in the provision of liquidity raises the question of whether appreciable gains might be had from coordination of monetary policies more generally. John is skeptical, and so am I. Gains from formal policy coordination never seemed large, and it is not clear that globalization has increased them appreciably. Policies agreed to under one set of circumstances may no longer be appropriate when circumstances change, as they inevitably will. Monetary policy should be able to adjust quickly to such changes; agreements that must be renegotiated can tie policymakers' hands. That does not mean that no circumstances exist in which coordinated monetary policy actions would be beneficial, but such circumstances are probably quite rare. Ultimately, global stability depends on good performance in individual countries, and the record of recent decades suggests that, in general, good performance is most readily achieved when central banks focus on their own mandates for domestic price stability and growth.

Kohn, of course, has to hold this view because all other central banks are coordinated, only the Fed is uncoordinated. And, given the vulnerability of Wall Street, the Fed is not going to become coordinated.

Meanwhile, Fed Governor Frederick Mishkin is busy minimizing the inflationary implications of a weaker Dollar:

Sizeable depreciations of the nominal exchange rate exert fairly small effects on consumer prices across a wide set of industrial countries, and these effects have declined over the past two decades. Exchange rate depreciations are thus likely to have less adverse effects on inflation than they have had in the past. The empirical evidence also indicates that pass-through from exchange rates to import prices is low and has declined markedly over the past two decades. This evidence suggests that there may be a weaker relationship between exchange rate fluctuations and nominal demand than prevailed in the past, which may make it easier for monetary policy to stabilize inflation and real activity.

True, Mishkin, like Kohn, adds the standard “we must still be careful to watch inflation expectations” line, but we all know at this point it is simply a throwaway line. Especially now that the TIPS market is revealing ever-increasing worries about inflation. We used to think the Fed paid attention to market based measures of inflation expectations. Apparently, they only paid attention when the news was good.

In the Fed’s defense, they see themselves as having few options.  The worsening of the credit crunch is the dominant concern, and note that while a reversal in commodity price and Dollar trends may help ease inflation fears, the financial community is using winning long commodity and short dollar positions to offset losses on credit market instruments.  Leverage in one direction to allow deleveraging in another. The Fed can’t exactly send those trades into a tailspin; there would be no place left to hide. Indeed, the Fed needs to feed a bubble somewhere – the “where” in this case is just terribly inconvenient as far as inflation concerned.

And for those ready to dismiss the commodity price bubble on the expectation that it will soon be tempered by slowing global growth, I would offer the rebound in the Baltic Dry Index as evidence that the stories of global economic collapse are premature. Even in my darker moments I try to keep in mind that a good chunk of the world’s central banks are working overtime to shovel money into the global economy to prevent a more dramatic fall in the Dollar. All that money has to have an impact somewhere.  And the money won’t stop flowing until global inflation rises high enough to trigger a backlash against Fed policy. Moreover, even if commodity prices are a bubble, a bubble can last longer than you expect.  Much longer.

Bottom Line:  The Fed will resist being pushed into a 75bp rate cut at this juncture. Indeed, given the amount of easing already in the pipeline, and rising inflation expectations, one could argue for a small 25bp cut or even a steady hand.  The FOMC, however, especially the most powerful policymakers, continue to dispel inflationary concerns, even as market participants take the opposing view. Another round of Fed vs. the markets.  The Fed has not fared well in those battles since last August.

    Posted by on Monday, March 10, 2008 at 12:31 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (12)

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