Tim Duy says, given the way things stand at the moment, to expect a quarter point cut in the target interest rate the next time the Fed meets:
Looking – Again – For 25bp, by Tim Duy: Market participants are once again split on the outcome of the next FOMC meeting, with the odds somewhat favoring a 25bp cut. I believe this is the Fed’s preferred policy choice as well – but they desperately need the news flow to give them an opportunity to pause, or at least slow the pace of rate cuts to allow them to assess their handiwork. I suspect this means they need financial markets to maintain some semblance of normality – or relative normality – over the next three weeks as I think that incoming economic data over that period has few implications for near term policy.
There are no tools the Fed can deploy that will magically bring the current financial turmoil to a close. Despite driving policy to what Former Fed Chairman Paul Volker describes as “the very edge of its lawful and implied power,” financial markets remain unsteady, with measures of financial pressure such as the TED spread down from crisis levels but well above anything close to normal. It took years for the financial community to build up its massive stock of complicated and intertwined debt holdings. Likewise, it will take a substantial period of time to unwind these ties, and while that process continues, the risk remains for another Bear Sterns type crisis – and such crisis would likely force the Fed’s hand in favor of the larger cut.
But lacking another full-blown financial crisis, the Fed will attempt to glide policy to a landing somewhere just below 2%. From the most recent FOMC minutes:
With the uncertainties in the outlook for both economic activity and inflation elevated, members noted that appropriately calibrating the stance of policy was difficult, partly because some time would be required to assess the effects of the substantial easing of policy to date.
The Fed has cut rates 300bp since September. This is a significant amount of easing, but its full force will not be felt until early 2009; one should not be surprised to see little if any impact in the current data. Moreover, fiscal policy will soon come into play, allowing the Fed to pass the baton to the US Treasury. To be sure, the Fed cannot stop cutting rates altogether at this point; that would undermine the fiscal stimulus that Fed Chairman Ben Bernanke called for back in January. And it will be politically difficult for the Fed to abruptly halt policy with nonfarm payroll growth in negative territory. But with so much easing already in the pipeline, the Fed can slow the pace to two more 25bp rate cuts before bringing the cycle to an at least temporary pause.
Note also that Fed officials do not believe that interest rate policy is ineffective due to strains in the housing and financial markets:
Members recognized that monetary policy alone could not address fully the underlying problems in the housing market and in financial markets, but they noted that, through a range of channels, lower short-term real interest rates should help buoy economic activity and ameliorate strains in these markets.
One objective of easy policy is to push the rate of return on safe assets to such low levels that you force the financial community to undertake more risky behavior. The problem, of course, is that the Fed cannot predict a priori where that risky behavior will manifest itself. In this past cycle, low interest rates drove a bubble in housing markets (I think it is ludicrous to argue that Fed policy did not fuel the housing bubble). This was a somewhat convenient for the Fed in that the headline price of housing is excluded from measures of inflation. Unfortunately, current policy is pushing investors into commodities, the impact of which is a bit more difficult to ignore. Commodities have an attractive underlying story (steady excess demand), are impacted positively by the falling Dollar, and are viewed as inflation hedge. Moreover, they have become a one way bet, supporting additional speculative flows. From Bloomberg:
Global investments in raw materials rose by more than a fifth in the first quarter to $400 billion, Citigroup Inc. said on April 7. A ''tidal wave of investment flows into commodity markets has further boosted prices,'' the bank said.
You may believe the commodity price surge is a bubble; fine by me. But a bubble can continue longer than expected, and have very real impacts on patterns of economic behavior. And with negative real returns on safe assets, investors will continue to support seemingly “safe” bets.
Note that the Fed is counting on stabilizing commodity prices to reduce inflationary pressures. In that light, the Fed must find the recent high in oil and gas prices to be something of a disappointment – yet another argument to be somewhat cautious on policy. Moreover, manufacturers are finding it increasingly difficult to hold the line on price increases. From today’s page 1 WSJ cover story:
The world's largest iron producer, Brazil's Companhia Vale do Rio Doce, known as Vale, got its customers to agree to a 65% price increase on ore from its main mine this year, far larger than last year's 9.5% increase. That led steelmakers like Baosteel Group Corp., China's biggest, to raise product prices by 17% to 20% in recent months.
"It will have a pretty big effect on our material costs," Jim Owens, chief executive of Caterpillar Inc., the big U.S. maker of construction equipment and engines, said on a recent visit to Beijing. Caterpillar is preparing price increases of up to 5% on its products to take effect by July.
In St. Louis, Solutia Inc. is raising prices for resins used to make laminated glass by up to 40%, blaming climbing costs for materials, energy and transportation. "We are now at a point where sourcing raw materials at continuously higher prices makes no sense for our business, unless the effects are passed on," said Solutia Vice President Luc De Temmerman.
Kimberly-Clark Corp., maker of household goods, began raising prices in February between 4% and 7% for some paper products, including Huggies diapers, Cottonelle bath tissue and Viva paper towels. Hershey Foods Corp. raised the selling price of its chocolate bars 13% in February after boosting prices between 4% and 5% in April 2007. Hanesbrands Inc., which owns the Champion and Hanes apparel lines, has warned that sustained high cotton prices could filter through to retail prices.
In the near-term, however, the Fed has little reason to worry of a return to a 1970’s type of inflation, as a worsening labor market should help keep the lid on wage gains. The resulting declines in real incomes thus helps correct years of excessive consumption in the US. Volcker again:
“Look. The basic economy is not irretrievably damaged in any way, shape, or form. We had to go through an adjustment, which is tough. It’s happening much quicker. You’d rather have it happen gradually. But I’m optimistic that, okay, we’ve got to get the consumption down, we got to get spending in line with our capacity to produce. I think that’s going on. And that process is going to take a while.”
My concern is that the Fed, and policymakers in general, do not share Volcker’s view of the situation, and thus will continue to error on the side of excessive stimulation, hoping not to just moderate the declines in consumption spending, but instead to completely offset those declines. Sustained policy in this direction over a period of years will lead to more widespread inflation.
It is worth remembering the global inflationary consequences of Fed policy are being supported by unsustainable policies in many emerging markets. Again from the WSJ:
The weakening U.S. dollar is another source. Not only is it pushing up prices of American imports, it is transmitting inflation to the dozens of economies that link their currencies to the U.S. dollar, from Saudi Arabia to Hong Kong to Mongolia. Because of their currency pegs, these economies are forced to track Fed rate cuts even if they aren't facing recession. That is putting upward pressure on their prices.
By the way, these economies are not “forced” to follow the Fed; their policymakers are making a deliberate choice, largely, I suspect, because they have lost the opportunity to easily transition away from their Dollar pegs. I am more worried about a future in which we see global monetary tightening due to intolerably high inflation abroad than the current Fed-driven global easing.
Bottom Line: The Fed continues to look for an opportunity to slow the pace of rate cuts; optimally, they need a chance to assess the impact of previous cuts. To date, the financial markets have not cooperated, with repeated turbulence forcing the Fed’s hand. If markets remain reasonably calm, expect another 25bp. If a fresh crisis arises, expect 50bp. I suspect commodity prices will continue to be a thorn in the Fed’s side as long as the world is, on average, supporting stimulative monetary policy.