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September 20, 2005
Something for Fed watchers to chew on
Today's FOMC statement was clearly a bit on the hawkish side. Let the blogtalk commence on what it means. I'll start with this.
What is a neutral fed funds rate, and how soon should we try to get there? This is pretty much equivalent to asking, when and at what rate to the hikes finally stop. A year ago, I said 3 to 4% in the next 12 to 18 months. We're there and not stopping. More recently I've been thinking 4 1/2% next spring. Now, 5% by summer is a real possibility, and if someone gave me even money on an over/under bet, I'd have to give serious consideration to "over".
They seem very comfortable with 25 b.p. at a time. The fact that they are not changing the measured pace language makes me confident that 50 b.p. moves are out of the question unless core inflation really makes a move. So to be "hawkish" right now seems to mean extending the time horizon for the increases rather than squeezing tighter and faster.
I suspect that many in the market, and many of you, probably have the same assessment. Does this mean that they are doing a pretty good job of managing expectations? Are expectations about the length of time the rate hikes will continue easier to manage than expectations about how big the steps will be or when there will be a pause? Is there anything, short of a drop in GDP, that would induce a pause before year's end?
My answers are yes, maybe, and I'm beginning to wonder. Comments are open.
Posted by William Polley at September 20, 2005 8:12 PM
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Comments
If the Fed, as embodied in a Taylor rule type
world, is aiming for a 2% real Fed fund rate,
the inflation of 3-3.5% suggsts that interest rates will get driven up to 5.5 or 5.75. Call me a pessimist but I'd go with the over bet.
Posted by: malcolm at September 21, 2005 1:09 AM
Yes, depending on GDP relative to potential. By the Fed's estimate (see here:http://research.stlouisfed.org/publications/mt/20051001/mtpub.pdf), we're probably not quite up to potential yet. Hence I'd not be in any hurry to get above 5%. Where you go from there depends on what GDP does for the rest of the year. If Katrina's (and now Rita's?) impact is small, maybe we keep going. If their impact is large enough to slow growth in the rest of 2005, I'm in less of a hurry to get to 5%.
Posted by: William Polley at September 21, 2005 8:51 AM
If a neutral rate was 3% to 4# a year ago,
why should it be higher now?
I'm not trying to make a point, I really
would like to see the answer.
Posted by: spencer at September 21, 2005 8:56 AM
you asked what might make the fed pause. i think they will watch consumption closely. the consumer drives the economy and if there is any sign that he( iguess to be pc ...she too) they will signal a slowdown quickly.......i am located in ny and i think that when regular middle class folk begin to pay their winter heating bills consumption will suffer.....in august 2004 i locked in oil for the heating season at 1.64 per gallon.this august i locked in 2.59..that is a chunk of money and cant be ignored.....natural gas consumers will suffer,too. so i think we should pay close attention to the spending side.....separately,the bond market is "en fuego" and yield curve has flattened dramatically sice fed statement.....that part of curve is flatter by 9bps.......jjj
Posted by: jjj at September 21, 2005 9:31 AM
I like the Cleveland FED's median CPI that is showing 2.3% annual inflation:
http://www.clevelandfed.org/Research/data/mcpipr.cfm
That would put neutral (assuming no pick up in inflation) at about 4.3%. I think 4.25% is the top FED Funds rate ... and I think we will start seeing signs of economic weakness soon with the housing market slowing ... so we might not even get to 4.25%.
Best Regards.
Posted by: CalculatedRisk at September 21, 2005 12:08 PM
I think the Fed will probably overtighten in the believe that they could easily stop and reverse course if it came to it. I am less optimistic the economy will be able to withstand and reverse as easily. It may take a decline in GDP growth below 2% before they relent.
Posted by: Lord at September 21, 2005 2:43 PM
Good comments, all.
Spencer: The only thing I'd say is that GDP reaching potential coupled with some red hot inflation expectations would push up my definition of neutral. Between now and spring I could forsee things happening that would cause me to want to go closer to 5%, but as I said, I'm in no hurry now.
CR: 4.3% isn't far off what my gut would have told me before Katrina. Assuming little long term impact from that, and that this months inflation expectations are a blip, I'm ok with that--maybe a wee bit higher, but it's a tough call.
jjj and Lord: Yeah.
Posted by: William Polley at September 21, 2005 4:43 PM