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August 9, 2005
Walking the tightrope
So here we are again on the day of an open market committee meeting. Not much to talk about in the way of what they will do, but plenty to talk about in the way of what they should do. Is the current round of tightening too much or not enough?
First, the news... (CNN)
Before the Fed meeting, the Labor Department announced Tuesday morning that unit labor costs, an important measure of inflation in the job market, climbed 1.3 percent in the second quarter. Economists expected a 2.75 percent result.
Productivity also climbed 2.2 percent during the second quarter, ahead of economists' expectations of 2 percent.
Macroblog has more, including links to other news articles from this morning. All in all, I'd say the morning news has my day off to a good start.
But as Jerry Garcia famously sang, "Every silver lining's got a touch of grey." You just can't get away from the long standing notion that a strong economy leads to inflation. Dave Altig's (macroblog) post points to a Bloomberg article that makes both of us cringe a little.
Reports in recent weeks have shown that even after nine rate increases since June 2004, with a 10th expected tomorrow, the Fed hasn't been able to slow the economy. The 10-year note yields less now than it did when the central bank began raising interest rates. The government reported that house prices in June jumped by the most on record and inflation is running at the high end of the central bank's estimates.
...
"The Fed is going to have to raise rates however high as necessary to get an effect on the housing market," said Jan Hatzius, a senior economist at Goldman Sachs Group Inc. in New York. Goldman forecast a year-end 10-year yield of 4.90 percent.
Count me in the camp that believes that pricking the housing bubble is not the Fed's objective here.
And here's an interesting observation (Forbes)
The market's attention will focus firmly on the FOMC's accompanying statement, with many expecting a slightly more hawkish tone in light of recent strong US economic data.
"People are thinking that the Fed may adopt a slightly more hawkish tone, and that is giving the dollar a bit of a boost at the moment," said Gary Noone, currency analyst at Informa Global Markets.
It doesn't get much more exciting than this, folks. In the overall scheme of things, not a lot has changed in the last 5 months. The labor market has improved (albeit more slowly than some would prefer) and GDP growth has been pretty strong (but not "overheating"). Inflation has, despite a number of anxious moments, largely remained in check. And here we are again with the bond market anxious--expecting hawkish words from the Fed to reassure them.
Here's a Reuters piece:
Treasuries have taken quite a whipping over the past two months, with benchmark yields spiking 40 basis points higher as expectations of an economic soft patch gave way to hopes for stronger growth in the second half of 2005.
A barrage of positive economic data has convinced investors that the economy is on a strong enough footing to allow the Federal Reserve to continue raising interest rates for a considerable time to come.
Coupled with upward revisions to inflation, the numbers are shifting the focus of the interest rate debate from a discussion about when the Fed could pause to a debate about just how far it might go, analysts said.
"The minutes of the upcoming meeting may show that a search for neutrality is being replaced by an inquiry into whether FOMC policy will need to turn restrictive in the coming quarters," argues Bruce Kasman, global head of economic research at JP Morgan.
Fed forecasters have adjusted their expectations for further monetary tightening accordingly to reflect a chance the central bank might actively nudge rates higher well into 2006.
What strikes me as odd, and a bit worrisome, is the idea that the economy has to hit a "soft patch" (for lack of a better word) to give the Fed the signal to stop raising rates. If Calculated Risk and Paul Krugman are correct that the housing market is starting to lose steam, then we might want to tread carefully.
I think that market forces (from yuan revaluation right on up the list) are going to push the 10 year yield up a bit regardless of what the Fed does. A pause in rate hikes might be just what we need in the 4th quarter. We've got a lot of rate increases in the pipeline. Although most of the increases were "priced in" some time ago, we need to remember that most of us weren't expecting to be where we are now when rates started rising a year ago. I'm not saying that it's time to stop--just time to pause. It's time to give the yield curve a little time to catch up. If market forces are gearing up to push long rates up anyway and the Fed is overzealous, that's just going to cause more problems.
Time to get away from the notion that a soft landing has to include a soft patch. As James Hamilton notes,
So where does that leave us right now? The Fed's expected rate hike next week will narrow the spread further. My nervousness about that is allayed somewhat by last week's favorable economic data. I'll be more nervous if the Fed raises rates again at the following FOMC meeting, and even more nervous if they raise rates again in November.
I get nervous when people talk about "slowing" the economy when real GDP growth has been remarkably stable in the (roughly) 3-4% range for a year and a half and some measures of the labor market have been slow to recover. Slowing right now would not be good, and it's exactly what would happen if you put one or two extra rate increases into the pipeline before we understand the effects of a year's worth of rate hikes.
I started the day feeling pretty cheery, and now I feel nervous. Well, check back in an hour and see if the FOMC press release has me in good spirits again. More importantly, check back to see what kind of spirits the market is in after the release.
Posted by William Polley at August 9, 2005 12:43 PM
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