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December 06, 2006
Would it help to print it in big, block letters?
Yesterday I wrote of the growing disconnect between the Fed and the financial markets:
Is it just me or are the markets trying like mad to find an argument for lower rates sooner? I think this would be a little frustrating for the Fed, which would like to bolster its inflation fighting credentials.
Now comes Greg Ip, writing in the Wall Street Journal:
WASHINGTON -- Federal Reserve officials -- unlike bond investors -- think the economy is a lot sounder today than at the end of 2000 and in early 2001, when the Fed abruptly reversed course and began a string of interest-rate cuts.
Yet Fed Chairman Ben Bernanke's effort to convey the message that today's conditions are different is hampered by the Fed's lack of candor back in 2000.
Fed officials, who have universally voiced concerns about inflation, are expected to keep short-term interest rates steady at 5.25% at their policy meeting next Tuesday. But bond markets have priced in a small chance of a rate cut next week and three one-quarter percentage-point cuts over the next 12 months.
Markets anticipate those cuts in part because they see parallels to 2000. A technology-stock and investment bust began to unfold in the summer of that year, yet in November the Fed still said its principal concern was inflation, not economic growth. Seven weeks later, with stock prices tumbling and businesses canceling investment plans, the Fed made the first of 13 interest-rate cuts.
Like stock prices then, housing prices today are turning down after a long run-up. But there is little sign the decline has spilled over into the rest of the economy. Stock prices are up, not down. Officials acknowledge recent data have been weak, especially for manufacturing and commercial construction, and they are expected to closely scrutinize the November jobs report, to be released Friday.
The weak data, however, haven't been corroborated by anecdotal evidence from the Fed's extensive business contacts. The Fed's recent "beige book" roundup of regional business conditions found "moderate growth" and "tight" labor markets.
In the comments to my post yesterday, spencer writes that he is more optimistic for lower inflation and interest rates and asks why he shouldn't be.
To which I would respond that I am also more optimistic for lower inflation than I was a month ago. That is, I am finding it easier to buy the story that the Fed has been giving us for the past few months that core inflation should be expected to moderate in 2007. Make no mistake, it is still above my comfort zone (and that of many of the FOMC members), but if the pressures that have been keeping it there are receding, I agree that the best thing to do is hold interest rates where they are now and allow the core inflation rate to fall back into the comfort zone and reassess things in a few months. Let bygones be bygones, as former Fed governor Laurence Meyer would say.
But I'm also still inclined to view today's short term rates as being pretty close to neutral--certainly more neutral than the 6.5% in place when the calendar turned from 2000 to 2001. The current rate is even a bit lower than it was in the 1995 "soft landing". The real interest rate was actually negative as recently as late as 2005--hard to argue that policy has been overly tight in recent months. The same cannot be said of 2000.
Most importantly, a rate cut here would not help long term inflation expectations. The longer that the core inflation rate remains out of the Fed's comfort zone, the more risky this becomes.
It's just hard to see a rate cut now (or in early 2007) as a risk that the Fed would want to take unless there was a pretty solid body of evidence pointing to a serious slowdown--more serious than most models are predicting. If it turns out that the forecast is wrong, then they will act. However I don't see them changing their course based on the bond market's comparison of 2006 to 2000. Indeed, I think it would damage their credibility to change course on that basis. Returning to the Wall Street Journal article, Ip interviews Edward Gramlich:
In late 2000, the Fed's business contacts were getting worried, and the stock market was crumpling as profit warnings proliferated. "Everything was pointing up and, all of a sudden, everything started pointing down," recalls Edward Gramlich, a Fed governor at the time. Today, "the key thing is whether the weakness in housing -- and now autos -- feeds over into consumption at large, and as I understand it, it really hasn't."
Trouble is, the bond market doesn't appear to share Gramlich's confidence that, as they say, this time it's different. And that has got to be frustrating for the folks at 20th and Constitution.
David Altig (macroblog) reads Ip's article as well.
Ip includes this comment:
"They're paid to worry about inflation, which means that until the slowdown is obvious and undeniable, they will stick to their forecasts," Ian Shepherdson, chief U.S. economist at High Frequency Economics, said in a report last week, citing the similarity to late 2000.
Altig responds:
... I'm not inclined to protest too much. I'll leave it to the sociologists and cognitive psychologists to figure out if being "paid to worry about inflation" somehow systematically biases the forecasts of policymakers. But just for the sake of argument, let's say it is so. Taking the long view, the not-so-arguable success of U.S. monetary policy over the past 25 years, and the memory that it wasn't always so, let me ask this: Would you really have it any other way?
No. And I wouldn't want to squander that success by allowing inflation expectations to creep up any further.
One more time over to Ip:
Transcripts of the Fed's November 2000 meeting offer grist for the skeptics. Fed officials at the time saw ample reason to shift from their assessment that higher inflation represented a greater risk to the economy than did weaker growth, to a view that the two risks were balanced. "The balance of risks has shifted quite noticeably," then-Vice Chairman Roger Ferguson said.
Mr. Kohn, then a staff adviser, said a balanced assessment of risks might well be merited, but could turn stock and bond markets frothy again. Then-Chairman Alan Greenspan agreed: "Were we to go to balance today we would almost surely end up tomorrow with financial conditions that would be too easy."
...
More so than Mr. Greenspan, Mr. Bernanke thinks it is dangerous for the Fed to slant its words to elicit a particular market reaction. Indeed, he was burned in April when markets misinterpreted his hints about a pause in interest-rate increases as complacency about inflation. That suggests he means his recent warnings on inflation to be taken at face value.
And so the problem boils down to this... Bernanke would probably rather not have to choose his words in such a way as to keep the bulls fenced in. But would you want to bet any amount of your paycheck that a more balanced assessment of risks would be interpreted correctly by the market? Ip is miles ahead of the bond market in understanding and interpreting Bernanke. That's great if you are a newspaper reader--not so great if you're a policymaker.
The Fed simply must continue to improve its communication strategy. This latest situation is the "measured pace" episode dressed up in different clothing. A change in language now will likely be interpreted as an announcement of a future policy change. That is not an ideal state of affairs, and I must say that I'm a bit more of an advocate of inflation targeting than I was when I got up this morning.
Posted by William Polley at December 6, 2006 11:26 PM
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