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August 4, 2006
The plot thickens
By now you've probably heard that payroll employment only increased by 113,000. And what did I just say?
Anything between 125,000 and 150,000 would cause me to raise my subjective odds of a rate hike slightly. Anything over 150,000 would raise those odds a bit more. If it does come in at less than 125,000 I'd be willing to listen to the argument for a pause again, but I'm not sure I'd flip.
Indeed, I am willing to listen. James Hamilton just posted his latest analysis showing that a pause is coming based on futures data, which he shows is a very good predictor. Hamilton writes,
In any case, the BLS release seems to have settled the argument, as least as far as the CBOT Fed watchers are concerned.
He's not alone. Here's a quote from the NY Times:
“This evidence should seal the case for a pause in rate hikes,” Nigel Gault, an economist with Global Insight, wrote in a research report today. “Given the slowing growth picture, the Fed is likely to decide that the prudent course is to await more evidence rather than risk overdoing the tightening” when it meets on Tuesday.
From the Wall St. Journal:
U.S. payrolls posted their fourth-straight tepid gain last month and the jobless rate spiked higher, likely giving Federal Reserve officials all the evidence they need to pause their two-year tightening campaign at next week's meeting of the Federal Open Market Committee.
"All the evidence they need"? "Seal the case"? Those might be a bit strong. Let's get one thing clear. The market does expect a pause. If you're predicting it based on what the markets (futures, bonds, and stocks) are saying, you've got to say pause. But that's not the end of the story. Will the Fed surprise the markets?
While my subjective probabilities may have changed, my basic analysis has not. Recent data has shown both a slowing economy and rising inflation. Given that the Fed knows how important it is to keep inflation and inflation expectations under control, they are paying very close attention to the inflation data. Until this morning's labor report, I would have (as I expect many at the Fed would have) put more priority on the inflation problem. The GDP report was not enough for me at the time.
But viewed together, the GDP report, the labor report, and other recent evidence all seem to point in the same direction. The economy is slowing. Not crashing. Not yet on the brink of recession. Slowing. Is that a reason to put the pause sooner rather than later? Perhaps. But I have a Ritholtz-esque concern. My concern is that if the Fed pauses on Tuesday the market interprets them as being done. If inflation does keep rising in the second half of the year, the accompanying rate hikes later could wreak havoc with the markets. How can the Fed prevent such misunderstanding? They'll need a very craftily worded statement. Something like, "...the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives" is not quite strong enough, I believe. Not exactly sure how I would word it, but if the Fed pauses now they need to clearly state that they will raise rates in October if inflation continues to rise.
With a well-worded statement, I could support a pause at this meeting. I still think that when they sit around the table on Tuesday they'll have enough ammo to support either decision. I've been anticipating a pause for a long time but for the last several months have been concerned that a pause too soon could allow real interest rates to fall too much and make things difficult later. And while I have been reluctant to bring it up because the Fed is somewhat independent of the political process (but then again, they don't operate in a vacuum either), it would be nice to pause in October before the election. Then comes December and the Christmas season. There is something to be said for firing one more shot now and hoping that you can ride out the rest of the year. (Just please don't characterize that as being "one and done".)
I want to believe that inflation will be kept under control by the lagged effect of previous rate increases, but I am not 100% convinced. I guess that makes me a "hawk" in the current circumstance. Overall, this is one of the toughest races I've ever had to handicap. I'd probably say 60-40 in favor of a pause in light of the labor data, which is in line with the IEM prediction at the moment. All I can say for sure is that whatever the outcome I will not be terribly surprised. The same cannot be said for the broader markets. They've made up their mind. I wouldn't underestimate the Fed's willingness to surprise them, but I wouldn't bet the farm on it either.
Working on a data oriented post (lest the blog be overrun with policy oriented handwaving)... should have it up this weekend. Have a good one.
Posted by William Polley at August 4, 2006 1:54 PM
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Comments
The evidence indicates the markets expect a pause. Copper rose 12 cents per pound, today. Two years ago that would have been a one day rise of 15 percent. Wait until next week after the fed pauses for another round of inflationary fireworks.Oil and commodities will go up big time.
The problem is that the fed doesn't understand the problem. The pce and other derivative measures of demand inflation and are lagging indicators. A pause now would be the wrong message and inflation will continue upwards. Had the fed raised rates agressively last year, we would not be in the pickle we are in now. They continue to be supportive of inflation.
It is a replay of the 70's. A pause is the same as monetizing the spiral, an accelerant. I would prefer to see them ease in a few months if the producer led inflation is ready to decline. The bogey man the fed is afraid of is the bogey man they created by not raising rates. Here we go again - why oh why can't the fed learn. It will get worse.
Posted by: quiz at August 4, 2006 5:25 PM
quiz - has it occured to you that monetizing the spiral is probably considered the best available option? Spiral up to meet house prices, then pull a Volcker when real wages more-or-less match home prices....compared to the other alternatives, this is probably considered a "soft" landing.
Posted by: RP at August 5, 2006 1:21 AM
RP
I saw how well monetizing the inflation worked in the 70's (and is working now). The idea of monetizing the asset price inflation caused by monetizing seems to me to be adding more fuel on the fire. A part of the spiral theory is that price inflation leads gains in wages, which are based on yesterday's inflationary experience.
I think there is just as good of chance of minimizing the housing defaltion by inverting the mortgage rate by snuffing out inflationary expectations. Refinancing ARM's at lower mortgage rates will reduce the cost of housing more quickly than wage gains. If the Fed pauses, I think that the dollar will fall, the mortgage rates will rise due to inflationary expectations, and the commodity prices will rise. We will end up with an acceleration. If they demonstrate resolve as inflation fighters, mortgage rates will fall and commodity prices will come under increasing pressure.
I do not see any effect on the underlying rate of inflation as a result of the Fed action so far. Oil prices and commodity prices continue upward.
I think the slow down is a result of the high and rising prices, not the half hearted attempt by the Fed to stabilize prices. Why would they pause, really. Will prices suddenly stabilize or will they continue to rise. I think the latter. Inflationary pricing is what is snuffing the expansion and monetizing it will cause more damage than not.
Posted by: quiz at August 5, 2006 7:13 PM