« If I hear one more "Evita" reference, I think I'll be sick | Main | Here comes the taxman....Boo! »
October 29, 2007
Thoughts on the Fed
Today's best article on the upcoming Fed meeting is in the Financial Times. Read and understand.
The Federal Reserve is likely to cut interest rates by a quarter-point to 4.5 per cent when its two-day policy meeting concludes on Wednesday. But the debate among Fed policymakers will be more finely balanced than is suggested by the odds in the futures market – in which a rate cut is seen as a virtual certainty.
According to anecdotal reports, there is some resistance among Fed insiders to the notion of a guaranteed rate cut. Many would have preferred to go into the meeting with market odds more evenly balanced, which would give the central bank greater latitude to make its determination without risking market turmoil.
It seems safe to say the Fed was not expecting to be in this situation when it cut rates by half a point in September. As Don Kohn, vice-chairman, explained shortly afterward, the Fed believed that by cutting rates more than expected it would get ahead of the curve.
The initial 50-basis-point cut was “a not unreasonable first approximation of what might be required to keep the economy on a sustainable path”, Mr Kohn said.
Indeed. Yet, some of the data that has come out since September has been worse than expected, particularly in the housing market. No need to rehash all of that here. We all know what has been going on. A sober assessment of the risks to the economy would have to include an increased recession risk since August and even since September. On that basis, it's hard to argue against a rate cut.
And yet, as an October cut has become more certain, it has also increased the likelihood that the market will expect future cuts. To feed into that belief would be a regrettable mistake. So how does the Fed tiptoe around this minefield?
First, they need to recognize that if there is going to be a housing induced recession, there is little that they can do about it short of refueling the housing boom, which is not an option. The cost of doing nothing may be slow growth for a couple of years. The cost of doing something may be a resurgence of inflation after a couple of years.
Higher oil prices and a lower dollar pose long term risks for inflation if the Fed is not careful. If the funds rate is below 4% in early 2008, I would become concerned about the inflation outlook going forward. They have to be very careful not to let expectations of inflation rise as that would just lead to more painful readjustments later.
The members of the FOMC know all of this very well, and I don't think they want a repeat of the last rate cutting cycle which went too deep for too long. And yet they will be tempted to yield to the siren's song. Ironically, it is less a matter of political pressure (as some say existed in the 1970s that led to inflation then) and more a matter of market pressure. Wall Street, not Pennsylvania Avenue, is addicted to the rate cuts. Even the scent of it in the air sends the Dow up these days. And as long as the Fed is worried about disappointing those who have made their bets at the Chicago Board of Trade, there is going to be a temptation to take the cuts too far. It's "measured pace" all over again but in the other direction. Remember how frustrated I was about that situation? I'm just as frustrated now. As wonderful as the fed funds futures market is, I'm sure that the inhabitants of the Eccles Building occasionally curse at it under their breath. That's why a communication policy revision is seriously in order.
Some kind of policy rule would really help. Because right now you have a situation where the market is guessing the Fed's next move and the Fed doesn't want to disappoint the market. Since market prognosticators are pretty bad at calling turning points, this makes it hard for the Fed to change direction. It's a setup for trouble, and is one of the better arguments for a policy rule such as an inflation target.
But since we don't have such a policy rule now, we will have to be content with simply wanting the Fed to make a statement that they are done for now, unless they aren't. As the FT article concludes:
More likely, policymakers will seek to balance a rate cut with a statement that tempers expectations of many more cuts to come. They will again hope they are done. But with economic uncertainty still high, they will want to leave open the option to cut again if necessary at the next meeting.
And you know what that means. We'll be having this same discussion again in a few weeks, unless they decide to send a signal that they are not beholden to the futures market and keep rates steady. As much as I might like the signal that it would send, it is an option that is not without risk. Perhaps a dissenting vote in favor of no cut could send the same message in a less risky way. I'm not convinced that the statement alone, no matter how strongly worded, would send the same message.
Marc Shivers thinks it will be 25 basis points as well. He bases this prediction off of the recent speeches by Fed officials. I've been reading those as well and I concur. Standing pat is a somewhat attractive option, and while a longshot, it seems more likely than 50 b.p. But ultimately, either extreme is too risky as it could roil the markets more than they want. If I were on the committee I would probably vote for no cut as long as I knew I would be in the minority. They will compromise on 25 b.p. and hope that they are done. (But I'd like them to prove me wrong by issuing a statement that really has some teeth.)
Posted by William Polley at October 29, 2007 11:48 AM
Trackback Pings
TrackBack URL for this entry:
http://www.williampolley.com/cgi-bin/mt-tb.cgi/878