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Tuesday, March 18, 2008

Fed Watch: Thoughts Headed Into the FOMC Meeting

Tim Duy with final thoughts before the FOMC meeting today:

Thoughts Headed Into the FOMC Meeting, by Tim Duy: Events are moving so fast it is hard to keep up, so I will offer a series of quick thoughts as we gear up for the details of the FOMC meeting.

1. Market participants expect something greater than 50bp tomorrow, and based on recent Fed history, I tend to agree.  Still, I have something of a thought that the Fed may think they can get away with a smaller cut – the Wall Street Journal raised this question, and I am still not sure why the Fed chose a meager 25bp discount rate cut rather than bringing the full package to the table Sunday night.  Was that a signal that they expected to deliver only 25bp today? Almost unthinkable, but the relative stability in Monday’s US markets could lull the FOMC into think only 25bp is necessary.  This is not my baseline scenario.

2. Talk of liquidity traps abounds, with Paul Krugman here and the Wall Street Journal here. There appears to be a sense that a liquidity trap leaves policymakers essentially dead in the water. Krugman is wise enough, however, to note that only “conventional” monetary policy has limits in this situation.  An unconventional solution available – simply monetize deficit spending. In another post, Krugman estimates that a financial bailout may be as much $3 trillion. He also questions whether even a smaller, Swedish style bailout is acceptable to taxpayers. And we haven’t even gotten to spending for a health care fix, or improved infrastructure spending, or better educational system, or…you name it.  It seems like there is no shortage of spending options that could be monetized. And do it enough, sooner or later we would generate enough inflation to pull the economy out of a liquidity trap. I am not saying this is the best option; you want to start by avoiding the liquidity trap altogether. Still, it is an option – and lately I have spent some time thinking about options for worst-case scenarios. And as I noted yesterday, Fed Chairman Ben Bernanke has spent just a limit more time than the average person thinking about monetization and liquidity traps.

3. knzn takes issues with concerns about capital flight and whether or not it imposes a constraint on monetary policy. He accurately notes that the US is not facing an issue of foreign currency denominated debts; we pay off our debts in Dollars, which we produce.  And that we are not (yet) defending a particular exchange rate, nor should we, as a weaker Dollar is stimulative. Also true – although there seems to be some concern that the Dollar has dropped enough. But I think we disagree more on his first point:

Full employment. If all your real domestic resources are being used, then the withdrawal of foreign capital will mean the withdrawal of real resources, which will reduce your growth potential. This was an issue for the US in the late 90s. But today the US is not at full employment. And if you still think it is, just wait a few months.

I think of the problem differently – the US is still faced with a massive current account deficit that necessitates a steady inflow of capital.  If that capital flow suddenly ceases, or worse, reverse, the US is going to have to quickly fill a very big financial gap.  The fastest way to fill that gap is import compression, which I suspect would happen by cutting consumption via a spike in unemployment. In other words, I think capital flight would necessitate a very painful adjustment, one that I would prefer to be drawn out over time.

4. knzn also take issue with the inflation concern from capital flight, noting that such concerns are rendered null and void after the last inflation report. I have mixed feelings on this issue. On one hand, I generally take the data as given, which argues for knzn’s interpretation.  On the other hand, the next time I speak to a group of community members, I sense that I will be laughed out of the room if I try to sell a story that inflation is zero. Note that the day the CPI was released, so was the Michigan Consumer Confidence report, which reported a spike in one-year inflation expectations to 4.5% for March, up from 3.6% in February (longer term expectations continue to hover around 3%). So, while acknowledging knzn’s point, for the moment I will follow Stephen Cechetti’s lead:

My reading of the detail this month suggests that the dip in inflation is likely to be temporary.  To see why, have a look information on core goods prices (commodities excluding food and energy).  This portion of the CPI (the weight is a bit over 20 percent) fell nearly one full percentage point (a.r.) in February.  Given that we import a good fraction of the goods we consume, and that the exchange value of the dollar has fallen precipitously over the past year, it is natural to wonder where this moderation is coming from.  To get a hint, we can look at a few things. First, the six-month change in core goods prices is +0.5 percent (a.r.). Core goods prices are rising.  And second, the decline is entirely a consequence of seasonal adjustment.  The not-seasonally-adjusted core goods price series rose at a 4.2 percent annual rate for the month.  Yes, that's right, seasonal adjustment turned a 4+ percent increase into a nearly 1 percent decline.  I'm not usually one to worry about stuff like this. I simply accept the seasons adjustments as they come.  But some years ago I learned that the simple mechanical algorithms used to adjust the data work poorly during business cycle turning points.  So, in this case I'm very very suspicious. 

As always, good luck today.

    Posted by on Tuesday, March 18, 2008 at 12:24 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (8)

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