Fed Watch: Between a Rock and a Hard Place

What will the Fed do in coming months?:

Between a Rock and a Hard Place, by Tim Duy: Fedspeak turned decidedly hawkish this week, and market participants responded accordingly, moving up expectations for a rate hike to as early as this August. But is Federal Reserve Chairman Ben Bernanke really ready to follow through? The answer could make or break the Dollar in the coming weeks.

Recall that just last week, Bernanke sent clear signals that rising near-term inflation expectations effectively put an end to the Fed’s rate cutting. But Bernanke’s concerns were quickly overtaken by events in two separate directions at the end of the week. First, on Thursday European Central Bank President Jean-Claude Trichet surprised markets by suggesting that the ECB’s next move might be a rate increase, as early as next month. Trichet’s comments were a slap in the face to traders betting that the interest rate differential between the US and Europe would narrow; instead, it looked like the opposite would happen, and markets needed to adjust accordingly. Dollar down, oil up – neither of which the Fed wanted to see. But this was only a prelude to Friday’s debacle that followed the release of the May employment report.

Market participants were looking for a stronger employment report. Initial unemployment claims fell last week, while the ADP report suggested the private payrolls actually increased. Instead of a strong report, the BLS reported what should have been expected – a continued erosion of the labor market. On the establishment side, the nonfarm payrolls decline was largely consistent with the story told by initial claims. On the household side, the jump in the unemployment rate was shocking, but was magnified by a surge of teenagers entering the job market (presumably seeking additional gas money).

I think discounting this impact is appropriate, at least until we see the June numbers. Still, even adjusting for the teen influx, the report was undeniably weaker than most expected, and brought into question the ability of the Fed to hold rates steady this year, let alone raise them. This realization sent the Dollar into a tailspin, while oil, aided by renewed tensions in the Middle East, rocketed to a new high.

Friday’s price action likely confirmed what Fed officials only grudgingly considered up to now – that they need to take seriously the idea that US monetary policy is directly impacting commodity prices, contributing to a deterioration of US inflation expectations. Bernanke was quick to react, downplaying the employment report, claiming that the risk of a substantial downturn has dissipated over the last month, and, to top it off, claimed that policymakers would “strongly resist” any rise in inflation expectations.

But does anyone believe Bernanke can follow through on this threat? According to MarketWatch, Fedwatchers are lining up to call his bluff. Across the Curve succinctly, and colorfully, describes the situation:

I think the 2 year part of the curve is oversold. I think (I know) the economy is weak. It is an election year and the unemployment rate just jumped to 5.5 percent. The housing market is a debacle. The Fed’s favored metric the core PCE has strayed very little from the top end of its prescribed range. Hemingway and Fitzgerald are not writing novels about World War One and this is not the Weimar Republic. The credit markets are frayed frazzled and fragile. Recovery has barely begun.

And hence we see the crux of the problem for Bernanke. Deserved or not, he has a credibility problem; at this point, he is seen as simply an inflationist hell-bent on fighting the Fed’s ghosts of the Great Depression. It is just so hard to believe that he would raise rates in the current environment, regardless of inflation expectations. We could believe Trichet. We could believe former Fed Chairman Paul Volker. But Bernanke? Still, with central bankers around the globe shifting gears to tackle rising inflation (see Bloomberg and WSJ), Bernanke may not have much choice. Any hint of hesitation to follow on the Fed’s part will likely renew the attack on the Dollar and push oil prices even higher, thereby undoing the recent string of jawboning.

But hiking rates is an equally dangerous path. Most obviously, the economy is clearly in a precarious position, temporarily held together by the flow of fiscal stimulus and cheap money. Raising rates would almost certainly upset this delicate balance. Furthermore, higher rates threaten to intensify and lengthen the housing downturn; a 30-year conventional mortgage is already at 6.25%. Note also the Fed would be raising rates into what many believe will be the second wave of mortgage problems, the Alt-A and option adjustable mortgages that reset beginning in 2009. If the Fed starts raising rates meaningfully at this point, anticipate the yield curve to invert early next year, signaling a recession in 2010.

Another risk is political. Normally, I would not place much weight on the importance of an election year, but to initiate a tightening campaign with rising unemployment and stagnating real incomes gives me pause. The political response is all too predictable: Why is the Fed so eager to support Wall Street in their hour of need, but equally eager to abandon Main Street when unemployment is rising? Indeed, I would not be surprised to see some Senators start jawboning the Fed by the end of this week. With four spots on the Board open for the next Administration to place, independence of the Fed cannot be taken for granted.

Bottom Line: The Fed has no one to blame for their predicament but themselves. Bernanke & Co. cut rates too deeply, fighting a battle against deflation that never was. Now they are backed into a corner; either raise rates and risk upsetting a very fragile economy, or stay the path and risk the inflationary consequences. If the Fed is truly concerned about the Dollar and commodity prices – and their open talk about currency values implies real and serious concerns – Bernanke will have to follow through with his newfound hawkish side. The bluntness of Fedspeak looks to signal a dramatic shift in thinking on Constitution Ave., and that argues for a rate hike by September, earlier than I had previously expected, and I cannot rule out an August move. Such a move is not without considerable risk for the economy.