Recently in Economics-Inflation Category

Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract, though the pace of contraction appears to be somewhat slower. Household spending has shown signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit. Weak sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories, fixed investment, and staffing. Although the economic outlook has improved modestly since the March meeting, partly reflecting some easing of financial market conditions, economic activity is likely to remain weak for a time. Nonetheless, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of financial and economic developments.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

A surprisingly light-hearted take on the U.S. economy from the Federal Reserve's policy statement sent government bond prices tumbling Wednesday, and yields vaulting to their highest levels for this year.

The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent. 

Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined.  Financial markets remain quite strained and credit conditions tight.  Overall, the outlook for economic activity has weakened further.

Meanwhile, inflationary pressures have diminished appreciably.  In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.  In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. 

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level.  As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant.  The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.  Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.  The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

It had to be done.  If we were to go another 6 weeks speculating about whether and when we would actually have quantitative easing, I'm not sure the market could cope with the uncertainty.  To go down to 25 b.p. is effectively an admission that they need to go to zero, so you might as well just do it.

Now the game has changed.  Say what you will about the fact that the normal monetary policy channels haven't been working for some time.  That is history now.  Tomorrow when they get up and go to work, they will have to come to terms with the fact that they have committed to operating in a whole new environment.  December 16, 2008 will be right up there with October 6, 1979 in the short list of monetary turning points--but the turn is in the opposite direction.

``There has been a policy shift, but the Fed is not transparently announcing what it is doing and why,'' said former St. Louis Fed President William Poole, now a senior fellow at Cato. ``Monetary policy works best when the markets understand what the central bank is doing.''

Some analysts point to the surplus cash that banks keep on deposit at the Fed as a key gauge of the Fed's monetary-policy stance. The so-called excess reserves have ballooned to $363.6 billion from $2 billion in August as the Fed added to its emergency lending programs.

``It is a move to quantitative easing, to force lots and lots of reserves into the banking system with the expectation that banks will start to trade them for a higher-yielding asset,'' said Poole, a Bloomberg contributor, said yesterday in a Bloomberg Television interview.

Hat tip to Calculated Risk.

Indeed, when you see things like this, it makes you wonder what is going on.  I'm going to be thinking about that a lot this week during the break from classes.

So what about deflation?  I'm not in the camp that thinks it's a big problem yet.  It becomes a real problem if wage declines make it even more difficult for people to make their mortgage payments or if price declines are so widespread and expected that people hold off spending now as they expect prices to go down further.  I don't see us getting there yet, but I stand ready to revise my expectations as new data arrives.

And finally stock market:  I'm just as caught up in it as you are.  My explanations are no better than anyone else's.  It does appear that we're on the verge of something with Citi, and people are getting worried about commercial real estate.  Those make for some strong headwinds. 

As I go around town I hear comments both positive and negative.  Everyone complains about their 401(k)s, but local businesses are hiring.  I do think that we're in a recession as we would define one nationally.  However, the impact is going to be very different for various regions and economic sectors.  It's difficult to fight recessions like this because it becomes more tempting to try to target policies at one area or another, and that's not always good or successful.

But it does give us things to talk about.

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 1 percent.

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability.

Recent policy actions, including today's rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, and San Francisco.

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Strains in financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending. Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Ms. Cumming voted as the alternate for Timothy F. Geithner.

My quick take is that it is very noncommittal about whether any rate cuts are forthcoming.  The inflation pressure still figures prominently in the press release, though they do expect inflation to ease.  This is an announcement that leaves all avenues open--and that is a very good thing.

In my intermediate macro class today, I lectured against a backdrop of the live (well, actually slightly delayed) tick-by-tick chart of the fed funds futures on the CBOT.  I was teaching macroeconomics as it happened.  You don't get to do that very often.

The Fed posted their minutes from the last FOMC meeting today. Check out the charts at the back that show the shift in the forecasts of the participants on variables such as GDP and inflation going out to 2010. There has been a noticeable shift since January. However, it does appear that the last meeting will be the last rate cut for a while. The Wall Street Journal's Brian Blackstone has a good summary of the minutes.

See also Donald Kohn's speech from yesterday.

Janet Yellen is on the lecture circuit. (Reuters)

"The 1970s were a horrible period. If there's one thing that has to be very high priority, we don't want to go back to a period that is anything like that," she said, critiquing presentations on the economy at a symposium for college students in Tacoma, Washington.

She is, of course, talking about inflation (not bell-bottoms or disco).

"During the 1970s the Fed failed to keep inflation low in the face of supply shocks (which) became incorporated into inflation expectations," Yellen said.

She acknowledges, as I think most of us do, that this is not a simple problem with a simple answer. She's worried about the prospects of lower growth as well. But the fact that she, as one of the more dove-ish members of the committee, is talking about inflation risks is a sign that the tide may have turned.

In my intermediate macroeconomics course, the final project is a simulation of an FOMC meeting where members of the class play the roles of Fed officials. They did exceptionally well. The presentations and discussion were excellent.

My class voted 9 to 7 to cut by another quarter point. (The 7 wanting to hold rates steady)

As far as I can remember, my class has never been wrong, and also as far as I can remember, when the class predicts dissent, there usually, if not always, is (though never as much in the real vote).

It's an unscientific indicator, to be sure. But it is very rewarding to see the students take it so seriously and really learn about how the Fed works.

The real meeting, of course, is tomorrow. More on that later.

I'm in the middle of a few things that are keeping me from blogging an extended analysis of the Fed's recent actions. But I did come across something today that will interest my readers. The WSJ Real Time Economics Blog opens a post with this:

Back in 2003, when the Federal Reserve cut interest rates to 1%, the world worried that the Fed was running out of ammunition and would soon have to turn to unconventional tools.

Now, in 2008, it’s worth asking if the Fed could run out of unconventional ammunition. Tuesday’s offer to lend $200 billion of its Treasury holdings to primary dealers in return for mortgage-backed securities both guaranteed by the government-sponsored enterprises (Fannie Mae and Freddie Mac) and not (private-label MBS) means it will have eventually sold or pledged half of its Treasurys, limiting how many more of these tricks it can pull off.

My first thought when I heard about this innovative move the Fed was that it would take the pressure off for a few days--maybe a week or two. And what then?

Meanwhile, on the other side of the Pacific...

From Reuters:

BEIJING (Reuters) - China's high January and February readings for inflation have increased the pressure on the government to take action to counter price rises, Commerce Minister Chen Deming said on Wednesday.

Annual consumer inflation jumped to 8.7 percent in February after hitting 7.1 percent in January, the worst in more than 11 years.

Here's a link to the new PDF version of the Beige Book. Here's the old html version.

The Wall Street Journal headline is "Beige Book Hints at Stagflation Amid Slow Growth, Prices Pressures"

I'm heading out the door, but I know what I'll be reading tonight.

... is from the Wall Street Journal's Greg Ip. In today's piece, "For the Fed, a Recession -- Not Inflation -- Poses Greater Threat", he writes:

So why is the Fed more worried about growth than inflation? First, it thinks run-ups in commodity prices explain the increases, not only in overall inflation but also in core inflation: higher energy costs have "passed through" to other goods and services. Core inflation rose and fell with energy inflation between early 2006 and mid-2007, and the Fed thinks the same thing is probably happening now. If energy and food prices stop rising -- they don't have to actually fall -- both overall and core inflation should recede.

...

For the current high inflation rates to become permanent, the Fed believes it has to become embedded in how workers and businesses set wages and prices. So far, surveys suggest consumers haven't raised their expectations of inflation much. In last year's fourth quarter, hourly wages and benefits were up just 3% from a year earlier, a slowdown from 2006, even though unemployment was below 5% for almost all that period. A wage-price spiral requires wages to cooperate.

Wages are even less likely to accelerate if unemployment, now 4.9%, rises to 5.25% this year and falls only gradually to 5% by 2010, as the Fed's Federal Open Market Committee forecasts. That implies three years with the unemployment rate above the FOMC's estimated "natural" rate of about 4.9%, and thus steady downward pressure on inflation.

The notion that higher unemployment reduces inflation has its skeptics, even at the Fed. "All you have to do is recall the 1970s, when we experienced both high unemployment and high inflation, to appreciate that slow economic growth and lower inflation don't necessarily go hand in hand," Federal Reserve Bank of Philadelphia President Charles Plosser said last month.

I must say that I get a little nervous about pinning my hopes for inflation reduction on a forecast that unemployment will be a couple tenths of a percent over the supposed "natural" rate. Even if you believe in some kind of an expectations augmented Phillips curve, you have to wonder about what has been happening in recent weeks. The genie may not be out of the bottle yet, but it's beginning to look like someone popped the cork.

Ip continues,

Critics say the Fed also took too long to reverse the ultralow rates of 2001-2003, thereby fueling the housing bubble -- if not rampant inflation -- whose collapse now threatens the economy. Federal Reserve Bank of St. Louis President William Poole became one of the first people who participated in that decision to repudiate it. "With the benefit of hindsight...it is not hard to argue that the [Fed] was too slow to raise the federal-funds target after taking the target down to 1% in 2003," he said at a conference on Friday.

Even Fed officials who don't share that view agree that both that episode and the 1970s experience argue for promptly reversing rate cuts once the current crisis passes.

That's easier said than done. The Fed is unlikely to face an outlook so unambiguously positive anytime soon that such a reversal will be a slam-dunk, and during an election year, it will face intense political pressure not to raise rates.

Whether the Fed reverses course "on an appropriate schedule" will be clear in five years or so, Mr. Poole said.

This is not the first place I've seen this sentiment (of rate hikes as soon as this crisis passes) expressed recently. That makes me think that there is a concerted effort to manage expectations here. At this point, I'd say the most likely time for the Fed to want to begin tightening again (barring any unforeseen developments) will probably be very close to election time. It will be a tough sell. Better start paving the way soon.

And Poole's final comment is very much on the money.

The news isn't good. The PPI is on the rise. (MSNBC)

WASHINGTON - Battered by bad economic news, consumer confidence plunged while wholesale food, energy and medicine costs soared, pushing inflation up at the fastest pace in a quarter century.

The Labor Department said Tuesday that wholesale inflation jumped by 1 percent in January, more than double the increase that analysts had been expecting.

The next paragraph isn't about inflation, but isn't great either...

Meanwhile, the New York-based Conference Board reported that its confidence index fell to 75.0 in February, down from a revised January reading of 87.3. The drop was far below the 83 reading that analysts had forecast and put the index at its lowest level since February 2003, a period that reflected anxiety in the lead up to the Iraq war.

And on another note, I was revising my homework solutions for my principles of macro course this semester. I always ask students to find the most recent rate of inflation by the CPI (12 month % change). Last semester, the answer was 2.0% at the time I asked the question. The answer now? 4.4%. (4.3% not seasonally adjusted)

Uh oh.

The Real Time Economics Blog conducts a Q&A with the president of the Philadelphia Fed. Among other things, Plosser says,

It’s a mistake to rely on the slowdown for much disinflationary effect.

However, he was in agreement with the recent 25 basis point cut, given the changes in the economy since October. Read the whole thing. A short article is also in the Journal.

Also in the Wall Street Journal today is a piece by Martin Feldstein. Here are some excerpts.

Further interest-rate cuts can reduce the risk of recession and increase output and employment in 2008 and 2009. The current 4.5% fed-funds rate is essentially neutral -- not low enough to stimulate growth and not high enough to reduce inflation. Although there are risks that the rise in oil prices and the falling dollar will raise the inflation rate, the greater potential damage of an economic downturn calls for a more stimulative policy. The Fed should reduce the fed-funds rate at its December meeting and continue cutting toward 3% in 2008, unless there is a clear sign of an economic improvement.

Because of current credit market conditions, there is a risk that interest rate cuts will not be as effective in stimulating the economy as they were in the past. The current credit crunch reflects not only a lack of liquidity, but also a lack of confidence in the creditworthiness of counterparties and in the accuracy of asset prices. This problem is now being compounded by the banks' loss of capital as they recognize past losses, and by their need to use large amounts of the remaining capital to support existing off-balance-sheet credits that have to be shifted to their balance sheets. All of this implies that lower interest rates may not raise lending and economic activity to the same extent that they did in the past.

The latter paragraph is a good follow up to Greg Ip's piece. In old fashioned Keynesian terms, what we've got here by this reckoning, is the basis for a liquidity trap. Later in the article, Feldstein adds the second part of his strategy.

What's really needed is a fiscal stimulus, enacted now and triggered to take effect if the economy deteriorates substantially in 2008. There are many possible forms of stimulus, including a uniform tax rebate per taxpayer or a percentage reduction in each taxpayer's liability. There are also a variety of possible triggering events. The most suitable of these would be a three-month cumulative decline in payroll employment. The fiscal stimulus would automatically end when employment began to rise or when it reached its pre-downturn level.

Enacting such a conditional stimulus would have two desirable effects. First, it would immediately boost the confidence of households and businesses since they would know that a significant slowdown would be met immediately by a substantial fiscal stimulus. Second, if there is a decline of employment (and therefore of output and incomes), a fiscal stimulus would begin without the usual delays of the legislative process.

You're probably familiar with the term "automatic stabilizers". Well this takes the concept to the next level. A tax cut conditional on economic data--that's an interesting suggestion. Unfortunately, the temporary nature of the cuts would tend to reduce their impact. Anyway, read on.

Even if the Fed decides that it should not cut rates further at the present time, it would not raise rates to offset the stimulus effect of the fiscal change. From the Fed's point of view, the tax cuts can provide a desirable short-run stimulus without the inflationary impact that would result from a lower interest rate and an increase in the stock of money.

Dust off your trusty old IS-LM model and let the fun begin.

Some reliance now on a fiscal stimulus rather than easier money would also take pressure off the exchange-rate adjustment. While further declines of the dollar are necessary to shrink the massive U.S. trade deficit, continued rapid declines might lead to counterproductive retaliatory actions by some of our trading partners.

Add a dash of Mundell-Fleming.

The excessive asset-price increases caused by some past monetary expansions -- especially the induced rise in the prices of real estate -- provide a further reason to use fiscal as well as monetary policy. By cutting the fed-funds rate to just 1% in 2003 and promising that it would be raised only slowly, the Fed contributed to the sharp rise in house prices and the market's current weakness. A mixed strategy that included a prospective fiscal stimulus would have reduced the Fed's perceived need for a sustained negative real fed-funds rate, and would therefore have produced a more balanced expansion of demand.

But didn't we cut taxes in 2001 and 2003? Yes, however those cuts were aimed in large measure at increasing long run growth--the success of which is a fair topic of debate. That's not to say that the short-run stimulative effect was nil. But the question is: would a temporary tax cut with a similar order of magnitude to the 2001 and 2003 cuts have any more stimulative effect? Or would people just save it?

Mark Thoma also mentions the permanent income hypothesis, but doesn't mention the 2001 and 2003 tax cuts. Interestingly, a lot of prominent economists opposed the 2003 tax cut because they thought it should be temporary (contrary to Thoma) in order to provide stimulus without threatening the long term budget outlook and that it should include a spending component (in agreement with Thoma).

I think temporary tax cuts won't work very well (in agreement with Thoma) and I have my doubts about temporary spending increases (more bridges to nowhere?), contrary to Thoma. So where does that leave us?

With a lower funds rate in 2008, that's where.

Chairman Bernanke spoke last night. Here's the full text. Here's the part that made everyone take notice.

With respect to household spending, the data received over the past month have been on the soft side. The Committee will have considerable additional information on consumer purchases and sentiment to digest before its next meeting. I expect household income and spending to continue to grow, but the combination of higher gas prices, the weak housing market, tighter credit conditions, and declines in stock prices seem likely to create some headwinds for the consumer in the months ahead.

Ok, first of all, the Fed needs to upgrade its web server to handle the extra load if they are going to give us any more days like this. I think all the people checking in at 1:15 (Central) might have brought down the server. I'm getting nothing right now.

Here's the CNBC story. The link to the statement will have to wait until their server catches its breath.

UPDATE: And here it is... FOMC Statement

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4-1/2 percent.

Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; Eric S. Rosengren; and Kevin M. Warsh. Voting against was Thomas M. Hoenig, who preferred no change in the federal funds rate at this meeting.

My first impression is that it is a good statement... better than the last. In the first paragraph (not counting the opening sentence), I see a reiteration that this move, with September's, should help forestall adverse effects from the housing trouble. In other words, I see this as telling the market, "You didn't get it last time but let's try this again. We're serious." Ok, maybe that could have been stronger. But there is an additional sentence about the inflation risks. That's good. There is a statement that the balance of risks is roughly equal. That is the key. That is a much stronger way of saying that the predisposition is going to be towards doing nothing unless something really serious pushes them off of that stance. It is a lot stronger than the previous statement. Though it will be ruthlessly parsed word by word in the next few hours, my initial read is that this satisfies me.

Hoenig dissented. Poole did not. Some might be surprised, but I was not. Poole's interviews lately have been pretty balanced. He has been upfront about recognizing the risk from financial instability. Hoenig, on the other hand, didn't get as much attention. But I do remember this item...

TULSA, Oklahoma (Reuters) - Federal Reserve Bank of Kansas City President Thomas Hoenig on Wednesday said he was keeping an open mind about the future direction of interest rates but was on alert for fallout from financial market woes.

"Wait and see," he cautioned an audience at a dinner hosted by the Kansas City Fed.

That was from October 17. I kept that story in my feed reader for some reason... as if I thought I might want to reference it someday.

And as I said before, the fact that someone dissented and asked for no change does a lot for making this a credible statement that says that they are done unless something at least a standard deviation out of the ordinary occurs.

Well, that was an interesting couple of days. Let's do it again in about 6 weeks... with a little less drama, maybe?

As of 9:30 (Chicago time) November fed funds were trading at 95.485 after starting the day at 95.495. Greg Ip's article may have spooked Wall Street, but at the corner of Jackson and LaSalle the expectation is, at this hour, still a 25 b.p. cut.

Click the image for the full size version. Source: Chicago Board of Trade (10 minute delayed quotes)

Electronic trading in fed funds continues overnight. You can see that when Ip's article hit the internet, the reaction was immediate but short-lived.

It should be an interesting 27 hours or so.

The Philly Fed is upbeat.

Activity in the region’s manufacturing sector picked up in September, according to firms polled for this month’s Business Outlook Survey. Indexes for general activity, new orders, and shipments increased, reflecting continued underlying growth. Firms continued to report a rise in prices for inputs, but price increases for finished manufactured goods were not widespread. On balance, the forecast for growth over the next six months has not diminished appreciably, even though, according to responses to special questions this month, over one-quarter of the firms said they are scaling back employment and capital spending plans because of the recent deterioration in the construction industry and uncertainty in financial markets.

...

Respondents continue to report higher prices for inputs this month. The prices paid index increased eight points, after edging lower in the previous three months. Thirty percent of the firms reported higher input prices; 7 percent reported lower input prices.

Less than 10% of firms surveyed expected a substantial decline in employment or capital spending as a result of recent developments.

I think I just heard a bond price drop. The 10 year yield stands at 4.63% and climbing.

John Palmer reads this article in The Economist on Chinese inflation and points out the four... count them, four... things they missed.

UPDATE: Thomas Palley also has a post on Chinese inflation that gets it right.

Compared to Friday the news is that there isn't much news on the liquidity front. The Fed today injected only $2 billion. That effectively takes out nearly all of what they put in on Friday. There still is an extra $12 billion or so from a 14 day repo that took place last Thursday. But the upshot of all of this is that according to CNBC the fed funds rate is trading at or just a little higher than the target.

In other words, nothing too out of the ordinary, and the Fed might just be content to let the funds rate sit a little bit higher today. It's as if they are telling the market not to count their chickens before they are hatched when it comes to that rate cut the street has been calling for. Everybody and their brother is talking about moral hazard, and rightfully so. It is still my opinion that a rate cut is not desirable and would only be used if something like what happened on Friday turned into something close to a true global meltdown.

But it didn't. Mr. Bernanke won this one. He stared down the analysts calling for a rate cut and didn't blink. He did exactly what was required of him and the Fed. Simply put, the funds rate started trading above the target on Friday. So the Fed injected the liquidity to get it back down to the target. Full stop. Nice job.

As I watched CNBC this morning, I also began to get a fuller sense, as did anyone else who was listening carefully, of what was really happening. I heard one of the analysts say that the leverage in the hedge funds had dropped dramatically and that a significant amount of cash had been injected into those funds. That, of course, is exactly what needed to be done, and when you step back and think about it, everything that happened on Friday starts to make sense. A lot of people were in some pretty risky positions and got out of those positions and onto firmer ground. Of course, on Thursday and Friday, without knowing what was really going on it looked like more of a panic. If it is true that the leverage has decreased, then there should be less of a chance of something like that happening again, or worse.

Are the hedge funds and the other big financial firms hunkered down to weather any more fallout from subprime delinquencies? We can hope so. And if it is so, it is largely because of the Fed's injection of liquidity on Friday that made that process take place in a more orderly fashion. When the final story is written, that action may look pretty heroic. But like all good heroes, the Fed would say they were just doing what needed to be done.

Of course, hearing that July retail sales were up more than expected also helped everyone get off to a good start today. But I want to call your attention to some other news, which I think will be the most under-reported story of today.

China's inflation rate now stands at 5.6% with food prices rising around 15%. Why mention that in the context of what the Fed is doing? Because just as the Fed has to be on guard for deflationary pressures being transmitted internationally, they need to be on guard from inflationary risks overseas. Higher prices from China are already showing up on our shores. The Fed needs to make sure that we don't end up importing inflation from China.

Of course that was far from our minds on Friday, and rightfully so. However, with that danger passed, at least for now, we need to keep an eye on the other risks out there.

As I did yesterday, I focus on CBOT binary call options at a strike price of 94750. As of 3pm:

Sept07 down 9, currently at 13
Oct07 down 7, currently at 25
Dec07 up 3, currently at 35

As an aside, a put option with a strike of 94750 last traded at 3 points, up 2 from yesterday. That's a contract that pays if the target fed funds rate is higher than the current 5.25% after the December meeting.

I call the last couple weeks, "Denial."

I just checked the Fed Funds Binary Options on the Chicago Board of Trade. Here is a link, but I do not know how stable it is. When trading opens tomorrow, the quotes will be different anyway.

Note to self: WIU economics faculty and students usually make a trip up to Chicago to see the Board of Trade every year. I am one of the faculty who works on scheduling and arranging the trip. I must do what I can to see if we can get up there on an FOMC day this fall.

From the closing quotes, it looks like it was an exciting afternoon. In fact, I was watching CNBC when the announcement came and at the moment the reporter started reading the statement the trading pit in Chicago erupted. That's the only word that comes to mind. The quotes tell the story of what they were yelling about.

Rather than detail them all, I will focus on just the call options with a strike price of 94750 (pays 100 if the target funds rate is less than 5.25% on the expiration date).

Sept07 down 7 to close at 22.
Oct07 down 6 to close at 32.
Dec07 down 18 to close at 32.

I think these pretty much speak for themselves. Roughly speaking, the market is saying that if they do cut, they cut by October. But it's only a 1 in 3 chance that they do it at all (this year).

UPDATE: The NY Times editors are in denial.

Despite the Federal Reserve’s stay-the-course message yesterday, investors are betting on at least one interest-rate cut by January, intended to quell turmoil in the markets and to juice the slow economy.

A couple days ago the market was saying it was 50-50. Now the market is saying it's (roughly) 2:1 against (or 1 in 3 that they will, if you prefer). Looks to me like some of them switched their bets.

They would have done well to listen to Cassandra.

David Leonhardt explains why records are made to be broken and why one must always adjust for inflation. (NY Times)

The S.& P. 500, which is a much better measure than the Dow, closed yesterday at 1,549, just 1.4 percent higher than the peak it reached in March 2000. Think about what that means. While the price of nearly everything has risen over the least seven years — while the price of bread has increased almost one-third, for instance — stocks have barely budged. They have only marginally outperformed cash sitting in a bureau drawer. So if we are going to talk about a stock market record, we should be doing the same for a whole lot of other things: Loaves of Bread Surge to New Highs

Once again the FOMC decided to keep the fed funds rate unchanged at 5 1/4 percent. (Read the statement) There were some minor changes in the wording compared to the May statement. For example, in the second paragraph it is said that economic growth appears to have been moderate "despite the ongoing adjustment in the housing sector." Previously it had said that "adjustment in the housing sector is ongoing." Today's statement strikes me as conveying a somewhat more positive spin than before. No doubt many will think that is not warranted at this time.

The more important change seems to have been in the next paragraph. Here's the new language:

Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.

And here is what they said in May:

Core inflation remains somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.

The line about "sustained moderation...has yet to be convincingly demonstrated" is a clever way to word it. At the same time, they say that readings on core inflation "have improved modestly in recent months."

Reuters focuses on the first sentence: (Headline: Fed holds rates steady, nods to ease in inflation)

WASHINGTON (Reuters) - The Federal Reserve on Thursday held benchmark U.S. interest rates steady at 5.25 percent for an eighth straight meeting and dropped a description of core inflation as "elevated."

King Banaian focuses on the second sentence: (Blog post title: This'll be icky)

The Federal Reserve held rates steady, but the markets will not like the references to inflation here:

...

The Dow was up 50 when the news broke; I'd bet that won't last.

As of this writing, the Dow is up about 24 points. That's down from earlier, but hardly a sign that this news sent traders running with their tails between their legs. The bond market is another story. The 10 year is down 8/32 at this writing with the yield at 5.11%. King also points out that the WSJ Economics Blog says that tomorrow's release of the May PCE will be closely watched. Indeed.

But I'm of the opinion that nothing in today's statement is truly market moving news. Yes, bond traders are more touchy about this than stock traders perhaps. They may recover some of those 8 ticks today or tomorrow after mulling this over. This statement is not a clear sign that the FOMC intends to get back into a tightening mode. At least the market is not interpreting it as a clear sign, and that's what counts.

However the Fed doesn't want to telegraph its move quite yet. They don't want to be locked in on the off chance that the spillover from housing is worse than imagined, or something like that. That would cost them credibility. On the other hand, you can only sit for so long with core PCE outside your comfort zone without losing some credibility too. Before the end of the year, I think they will have to decide where they are going. If the growth picture looks about the same as it does today, and if core PCE is still on the high side, I think you know which way I would like them to go.

UPDATE: Dave Altig at macroblog links to some of the financial media coverage which was, as one might expect, all over the map. One of the more reasonable comments was from the Wall Street Journal (no link provided) which suggests that this really wasn't much of a substantive change. It's as if they were changing some of the wording (removing the word "elevated") just to keep people from fixating on the language that had been used for a while.

I'd like to think that's the case since it fits with a view that I have had ever since they overused a certain phrase a couple of years ago.

Last week, James Hamilton led off a post with the line,

Let's admit it-- the other shoe is not yet dropping.

Opinions differ on what it will sound like when it does. April employment numbers came out day (+88,000 non-farm payroll jobs), and PGL doesn't like what he heard.

The fall in the household survey reporting of employment was 468,000. The unemployment rate would have risen even more had it not been for the fall in the labor force participation rate (LFP). The decline in the employment to population ratio (EP) was disappointing. Maybe it’s time that the Federal Reserve lower interest rates.

Then Craig Newmark points us to a Bloomberg article that says,

April 30 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke's assertion that interest rates may need to increase to curb inflation is wrong. That's what Goldman Sachs Group Inc., Merrill Lynch & Co. and UBS AG are saying.

While Bernanke warned last month that the odds of worsening inflation have increased, chief economists at the three firms say the worst housing slump in a decade may drive the U.S. economy into a recession and stifle consumer prices. Their chief economists say the Fed will cut its target for overnight loans between banks at least three times this year.

...

Bernanke is missing ``the linkage between residential housing investment and the broader economy,'' Jan Hatzius, chief U.S. economist at New York-based Goldman, the world's most profitable securities firm, said in an interview. ``The housing downturn is of the first order of importance.'' Hatzius says the Fed will cut rates three times this year, to 4.5 percent from 5.25 percent.

Kash says it's too early to tell if and when rates will fall.

While disappointing, it is hard to imagine today's data having any impact on the outcome of next week's FOMC meeting, at least in terms of the policy action. Whether it will cause policymakers to prepare to soften their stance in the coming months is another question. My guess is, not yet. The change in language in the last FOMC statement made a lot of people thing that rate cuts are now off the table. I don't think that is the case, but rather that a rate cut in 6 to 9 months is more likely than it was a few months ago.

After today's employment report, my subjective probability assessment for the funds rate in 6 to 9 months has edged even a bit more towards a rate cut.

So as we head into the week of the FOMC meeting, the question is whether and when they will make a more direct reference in the press release acknowledging that the risk of slower growth is greater than the risk of inflation. Predicting when and if that will come is like predicting when "measured pace" would disappear last year. Lots of people will call it before it happens, and a few will be surprised. But the Fed knows that they have to choose their words carefully, and in this instance it may mean that a rate cut will come without a lot of advance warning provoking speculation in the financial markets. The relevant reference for you is January 2001. If a rate cut comes, it could very well take us by surprise in terms of its timing. If, on the other hand, things improve this summer and a rate hike becomes necessary, the signs will be much more clear.

And so we sit, still waiting for the other shoe to drop.

I'm still here. There were just a lot of other pressing demands on my time for the last couple weeks. Among them were three trips out of town that required some preparation time before each one and not much down-time between them. The most recent was last Friday when I, along with a couple of other faculty members, took a group of our economics students to Chicago to do some career networking as well as touring the Board of Trade and Federal Reserve. We have a number of Western Illinois alumni in Chicago working in a variety of capacities and utilizing their degrees in economics. It is rewarding to connect with them and let them interact with our current students. Plus, everyone should see the closing bell at the Chicago Board of Trade at least once in their life.

The last few weeks also took me to Minneapolis for the Midwest Economic Association annual meeting where I finally met Phil Miller in person after knowing him through the blogosphere for two years. Shortly after that, it was over to Peoria for a presentation to some old friends at Bradley University's Economic Workshop for Clergy.

Of course, all this time I was also trying to stay one step ahead of my graduate students who have, with 6 class sessions remaining, surpassed where I ended the semester last year. I keep raising the bar and they rise to the challenge. That is the kind of work that I don't mind doing.

I have not been oblivious to the news of the last couple weeks. The release of the Fed minutes last week almost brought me out of hibernation, but ultimately realized that most of what I would have said would have been a rehash of what I've said before. Recall that in my last missive to you before my hiatus, I made it clear that I wasn't buying the market's interpretation that we could see a rate cut by summer. Last week we read in the minutes...

The Committee agreed that further policy firming might prove necessary to foster lower inflation, but in light of the increased uncertainty about the outlook for both growth and inflation, the Committee also agreed that the statement should no longer cite only the possibility of further firming. Instead, the statement should indicate that future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

That is pretty consistent with my interpretation. The market balked but appears to have recovered. As you know I have not been impressed with the market's ability to interpret the Fed's words. One of my favorite sentences I have written on this subject in the last few months is...

...would you want to bet any amount of your paycheck that a more balanced assessment of risks would be interpreted correctly by the market? (December 6, 2006)

So in other words, I didn't really feel like anything had changed last week.

But this plateau in interest rates cannot last forever, and I would regard it as fairly likely that rates will move one direction of the other before the year is up. So there will probably be some excitement this summer. We will all be closely watching the GDP figures as they come in, beginning with the first quarter in a couple weeks. And with my schedule freed up a bit relative to the last couple of weeks, I look forward to blogging as much of it as I can. Putting some time into other pressing activities was necessary, but it has refreshed me for blogging. One might even say that I'm hungry to get back into the groove.

This NY Times article is right. Watching Zimbabwe over the last few years has been like watching a tragedy in slow motion. You don't know exactly how it will end, but you know it will end badly. Here's the latest installment:

JOHANNESBURG, Feb. 6 — For close to seven years, Zimbabwe’s economy and quality of life have been in slow, uninterrupted decline. They are still declining this year, people there say, with one notable difference: the pace is no longer so slow.

Indeed, Zimbabwe’s economic descent has picked up so much speed that President Robert G. Mugabe, the nation’s leader for 27 years, is starting to lose support from parts of his own party.

In recent weeks, the national power authority has warned of a collapse of electrical service. A breakdown in water treatment has set off a new outbreak of cholera in the capital, Harare. All public services were cut off in Marondera, a regional capital of 50,000 in eastern Zimbabwe, after the city ran out of money to fix broken equipment. In Chitungwiza, just south of Harare, electricity is supplied only four days a week.

The government awarded all civil servants a 300 percent raise two weeks ago. But the increase is only a fraction of the inflation rate, so the nation’s 110,000 teachers are staging a work slowdown for more money. Measured by the black-market value of Zimbabwe’s ragtag currency, even their new salaries total less than 60 American dollars a month.

The article goes on, and I encourage you to read it all. Here is just one choice example of how things are going so very wrong:

Seeking to revive farm production, for example, the government sells gasoline to farmers at a bargain rate of 330 Zimbabwe dollars per liter — and farmers promptly resell it on the black market for 10 times that, leaving their fields idle.

The anecdotes coming out of Zimbabwe are beginning to sound like scenarios made-up for textbook examples, but they are not hypothetical. This is happening...right now...to real people.

And you just know it is going to get worse.

PGL at Angry Bear picks up on my comments from last night, as I hoped someone would. He quotes extensively from the 10 point WIN proposal and notes that Ford also called for capital gains tax cuts and investment tax credits. So allow me to call attention to point number nine:

Number nine: Federal taxes and spending. To support programs, to increase production and share inflation-produced hardships, we need additional tax revenues.

I am aware that any proposal for new taxes just 4 weeks before a national election is, to put it mildly, considered politically unwise. And I am frank to say that I have been earnestly advised to wait and talk about taxes anytime after November 5. But I do say in sincerity that I will not play politics with America's future.

Our present inflation to a considerable degree comes from many years of enacting expensive programs without raising enough revenues to pay for them. The truth is that 19 out of the 25 years I had the honor and the privilege to serve in this Chamber, the Federal Government ended up with Federal deficits. That is not a very good batting average.

By now, almost everybody--almost everybody else, I should say--has stated my position on Federal gasoline taxes. This time I will do it myself. I am not-emphasizing not--asking you for any increase in gas taxes.

I am--I am asking you to approve a 1-year temporary tax surcharge of 5 percent on corporate and upper-level individual incomes. This would generally exclude from the surcharge those families with gross incomes below $15,000 a year. The estimated $5 billion in extra revenue to be raised by this inflation-fighting tax should pay for the new programs I have recommended in this message.

Ford was not a Pigouvian--that much is certain. However, one can see that his understanding of fiscal policy was probably more nuanced than that of many presidents due to his experience in the House. In point number five, he asked for spending to help provide public service employment during the time of recession (you might think he sounds like a quaint New Dealer at this point). But he realizes that this together with the investment tax credits would balloon the deficit if there wasn't some kind of offsetting tax increase. This is the point that I wanted to make earlier, and I thank PGL for the comment that gave me an excuse to refine the point.

This point number nine in the WIN proposal was, however, the only place I could find reference to Ford calling for tax increases, which is why in yesterdays post I was careful to state that he called for tax cuts as well. But, like PGL, I found this to be a rather curious thing. As PGL points out, Ford also calls for monetary restraint and lower interest rates as well. There were some contradictions there. After reading the whole proposal, I get the feeling that he was trying to be revenue neutral (increasing some taxes and decreasing others) while stimulating economic growth and reducing inflation. The cynic in me wonders why he didn't ask for a pony as well, since this was already an impossible list.

But the better part of me wants to cut him some slack. This was two months after taking office in a most undesirable way and one month after making a tough decision that cost him politically. Why not lay it all out on the line? WIN was an impossible dream. Anyone who thought it would whip inflation and bring back prosperity before the 1975 State of the Union Address was not being honest with himself. But Ford did start the ball rolling on some important initiatives that included tax reform and regulatory reform. And the WIN speech was where some of those ideas were rolled out. As usual, Gerald Ford was thinking beyond the next political cycle. Such thinking tends not to get one re-elected, but we could use a bit more of it. The biggest problem with WIN, as I see it, was that it was bound to fail as a short-run solution even though certain aspects of it would have carried long-term benefits. That is a familiar problem in political economy.

As the months wore on, it was the tax cuts that took center stage in Ford's economic policy, but his was not a policy of tax cuts for the wealthy alone. He vetoed a bill that didn't include enough tax relief for the middle class and that didn't include spending cuts.

PGL concludes:

By the time Gerald Ford made this speech, the unemployment rate had increased from 4.9% to 5.9%. By May 1975, the unemployment rate reached 9% and still at 7.7% when voters went to the polls to decide between Gerald Ford and Jimmy Carter. My problem with the WIN program was less its details and more with the fact that this President seemed to ignore the fact that we were on the verge of a rather significant recession.

Check that. By NBER dating, the economy had already been in recession for just short of a year when he made this speech and was only 5 months away from pulling out of it. The labor market is a lagging indicator, so while the unemployment rate was still high, it was trending downward as Carter took office. He was a victim of poor timing in that regard. That is, unless you are going to tell me that the continuation of that trend and a decline of 1% in the unemployment rate in Jimmy Carter's first 12 months in office was due to Carter's economic policies. If so, I would respectfully disagree. Remember also that Ford had to work with a heavily Democratic congress. The wheels turned slowly. The divided government, while perhaps slowing the recovery, also kept either side from pushing the pendulum too far to either side and led to a slow but sustained recovery until the oil crisis reared its head again in Carter's term.

President Ford was dealt a really bad hand. He restored a measure of respect to the office and kept a bad economy from deteriorating any further. He used the power of the veto pen to stand up for fiscal responsibility. He put the nation's interests ahead of his own more than once. He did all this with civility and grace that is becoming ever more rare. He is not the sort of person we tend to elect, but he was there when his country called. He leaves a meaningful legacy to American politics.

UPDATE: Macroblog has more discussion of WIN. David Altig writes:

Seen through contemporary eyes, it is clear that the President Ford's speech hopelessly entangled shocks to relative prices with ongoing inflation of monetary origins.

Indeed. It was, to be blunt, a rather confused attempt to set out inflation's cause and cure. It was a political attack on a monetary problem. It's more about taxes, spending, and conservation. Altig continues:

Are there are any kind words to be found about all of this? More thoughts to follow.

I have tried to find kind words. However, I want to be clear that my kind words are more about what Ford's longer term objectives may have been, and what some of the WIN proposals, and indeed Ford's proposals more generally, were designed to do. I still think that WIN was misleading advertising and a set-up for failure in the short-term. But it was better than Nixon's price controls. Are those the kindest words? I look forward to hearing David's additional thoughts.

UPDATE: Altig does have some nice words to say. James Hamilton, on the other hand, is less charitable. Hamilton says:

And, despite the clever arguments that Dave brings up in the WIN button's favor, I think one great disservice of that campaign was to cultivate the misperception that inflation is somehow the responsibility of ordinary U.S. citizens. In my view, maintaining the purchasing power of a dollar is instead exclusively the responsibility of the people who control how many dollars get printed.

In the long run, yes. In the short run, other things do affect measured inflation, and WIN tried to affect some of these. I still think that it was ill-advised and a set up for failure because it created expectations that could never be fulfilled in the short run (because of politics and policy lags) or the long run (because of Hamilton's argument). Though you must admit that Ford was between a rock and a hard place on this, and although the buttons may have been overkill, some of the policies were worth a shot.

The ECB has raised their key interest rate from 3.25% to 3.5%.

This time, it comes from Ed Leamer, who is worth listening to: (Reuters)

SAN FRANCISCO (Reuters) - The U.S. economy will expand at a weak pace next year, setting the stage for lower interest rates, according to a UCLA Anderson Forecast report released on Thursday.

The forecasting unit's latest report projected quarterly real gross domestic product growth no higher than 2.7 percent next year, reflecting the weak housing market.

...

As a result, the Federal Reserve will cut interest rates to stimulate business, said Edward Leamer, director of the UCLA Anderson Forecast.

"We think the Fed will shift from an inflation concern to a sluggishness concern so that we'll get some rate cuts," Leamer said, adding that he sees the Federal Funds rate falling to 4.5 percent by the fourth quarter of next year.

...

Manufacturing has already shed so many jobs it is in no position to produce the kind of massive layoffs that paired with a housing downturn would trigger recession, Leamer added.

"We've trimmed it to the bone," Leamer said, referring to factory work. "It's already lean and mean."

Additionally, the economy will avoid recession because credit is abundant and consumers will continue spending at a moderate pace, Leamer said.

Interesting. Their prediction of moderate growth (2.7%) is certainly less than average, but equally certainly not indicative of a recession. It is quite similar to the GDP growth in 1995 (a "soft landing" year). And while there were two rate cuts in 1995 (and one more in early 1996), those cuts were to bring the funds rate down to 5.25%. Ironically, that's where we are now. So, while I'm not ready to predict three rate cuts in 2007 to bring the funds rate down to 4.5%, I would say that the UCLA forecast is in the ballpark.

Given all that has transpired in recent days, I would regard a rate cut in the first six months of 2007 to be more likely than a rate increase in that same time frame. That said, I continue to hold to the view that a rate cut at this time would slow the return of core inflation to its comfort zone. The fact that productivity is not growing as fast as it was in the first half of the year and that Mr. Bernanke has suggested that potential output growth may be slowing only serve to reinforce that view. Unlike 1995 and 1996 when productivity was rising rather than falling, the Fed will not have the luxury of cutting rates while inflation trends down.

The part of me that wants to give a prediction that is right is turning to the view that there will be at least one rate cut in 2007.

The Cassandra in me is having a tough time with that.

UPDATE: Calculated Risk quotes the LA Times version of the story, which includes Leamer quotes such as:

"If you are a builder or a broker, it will feel like a deep depression," he said. "But the rest of us will hardly notice."

and...

His conclusion: "The models say 'recession'; the mind says 'no way.' I'm going with the mind."

UPDATE 2: Leamer isn't alone. At least some people's models agree with his mind.

NEW YORK (Reuters) - The economy will likely pick up in 2007 after output growth slows rapidly in late 2006, according to a survey conducted by the Philadelphia Federal Reserve Bank released on Thursday.

Economic growth for 2008, released for the first time in the survey, was forecast at 3.0 percent.

Economists lowered their forecasts for U.S. growth in the first half of 2007 to 2.8 percent from 3.0 percent when the previous survey was taken six months ago. They forecast growth at 3.1 percent for the second half of 2007.

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.

3rd quarter real GDP grew at a 1.6% annualized growth rate. King asks how bad this really is and says that it's pretty bad, but not as bad as some will make it out to be. Brad DeLong says, "Gork!" Nouriel Roubini pats himself on the back for an excellent forecast. And he goes on to say:

What do these Q3 growth figures imply for Q4 and 2007 GDP growth? Expect today the usual spin with the soft-landing optimists – who were altogether wrong on Q2 growth and even more wrong on Q3 growth – having already started to spin the fairy tale of a Q4 rebound. This Q4 rebound has, so far, no base or data behind it: residential investment will be falling at a faster rate in Q4 than in Q3 given recent data on building permits and housing starts; non-residential investment that was, until now, growing very fast will sharply decelerate in Q4 and much more in 2007: see the lead story in the WSJ today referring to a McGraw Hill Construction study forecasting a rapid fall in construction spending in 2007 (including non residential construction and specifically stores and shopping centers), the first decline of construction spending since 1991.

No spin here. I do admit to being more optimistic than Roubini, but even so I am open to letting incoming data refine my position. I do not predict a 4th quarter rebound. Even if this is something approximating a soft landing, we're not out of the woods yet. Looking at the contributions of the different components of GDP to the overall growth rate, I cannot see any reason to expect anything much over 2% for the 4th quarter even under the best of circumstances. I would not be surprised with a number between 0.5 and 1.5%. Less than 0.5% would surprise me but not shock me. Residential investment will continue to be a drag on GDP, no argument there. However on the plus side, retail sales are continuing at a decent pace. Inventories are basically unchanged suggesting that firms still have some pricing power and consumers haven't yet let the housing slump get them down. Unless something suggests that the bottom is in the process of dropping out as we speak, I don't see 4th quarter GDP to be markedly worse than the 3rd.

Tim Duy makes the following observation:

Also, there is a reasonable chance that investment spending is held back by the delayed launch of Windows Vista. And note this from Bloomberg:

Norfolk Southern Corp., the fourth-largest U.S. railroad, boosted freight rates, helping third-quarter profit increase 38 percent. Sales rose 11 percent.

''Overall, we don't see any drastic slowing of the entire economy,'' Norfolk Southern Chief Executive Officer Charles ``Wick'' Moorman said in an interview. ``We think that pricing power will stay with us for a while.''

I pay attention to what the rail barons say – they generally have a good sense of economic activity.

Indeed. So while an actual prediction of a recession may be a bit premature, there are still many uncertainties that cloud the picture as we move from winter into spring. I will be paying close attention to the holiday spending figures. But interpret the early numbers with caution. The day after Thanksgiving isn't what it once was. Internet shopping peaks in mid-December. Some internet shoppers have already been at work (propping up 3rd quarter consumption?). This article on the subject is a year old, but probably still a good guide to what to expect.

The bottom line is that we are probably in for two or three quarters of below average growth. The 1995 soft landing was harder than what we have experienced so far--a fact that hasn't been mentioned much. By no means would I predict a reversal of the current trend and a return to 3+% growth yet. This report probably didn't surprise anyone at the Fed, nor would a slightly worse report in the 4th quarter. These figures support the position that pausing when they did was probably the right thing to do, but do not give any clarification about what is to come next (i.e. which will come first, a cut or an increase in rates). Staying the course still seems like the best option.

In closing, I point out a report that I have not seen getting a lot of play yet. From Bloomberg:

Oct. 27 (Bloomberg) -- An unexpected increase in auto production last quarter was a statistical fluke that will be reversed, making current U.S. economic growth even weaker, according to a former Commerce Department economist.

Last quarter's annualized 26 percent increase in motor vehicle production shocked Joe Carson, now director of economic research at AllianceBernstein LP in New York. Without the gain, the economy would have grown at an annual rate of 0.9 percent, not the 1.6 percent the Commerce Department reported today.

The reported increase in output came despite cutbacks announced by General Motors Corp., Ford Motor Co. and others. A drop in the wholesale price of SUVs and light trucks as the automakers cleared leftover 2006 models made production look stronger than it actually was, said Carson. The economic fallout from the auto-industry cutbacks will instead come this quarter, he said.

``Last quarter was weak even with the benefit of this mismatch and the fourth quarter will now also be weak because it's going the other way,'' Carson said. ``Whatever output you have this quarter, which will probably be down, will be discounted by a likely rebound in prices.''

Carson stressed that there wasn't an error in procedure requiring a correction from the government. It's the way the Commerce Department always computes the data and doesn't mean the statisticians committed any mistakes, he said.

Adjusting For Prices

The mismatch can be explained by looking at how the government adjusts the figures for price changes.

Commerce Department economists use wholesale light truck prices, from the Labor Department's producer price report, to eliminate the influence of inflation on investment and inventories for that category. A 5.5 percent drop in price of SUVs and other light trucks last quarter made output look stronger when adjusted for inflation, Carson said.

Declines in shipments of vehicles and parts from the Commerce Department's durable goods report over the last three months and in the Federal Reserve's output numbers in its industrial production figures, reinforce forecasts that the fourth-quarter growth numbers will show the auto cutbacks, Carson said.

Read the whole thing. Chain weighting looks at the percentage changes in constant dollar GDP for adjacent periods. So if firms cut prices to get rid of inventories, it would show up as higher growth in GDP from the production period to the sales period than if prices didn't fall. The size of the influence on overall GDP growth is larger than I would have thought, but I'll take their numbers at face value. How much it affects the 4th quarter depends on the slowdown in production. We shall see. But it's just one more thing to keep in mind going forward.

A couple of dynamics seem to be at work in the CPI numbers released today. Obviously the fall in gas prices decreased the headline number which was down by 0.5%. That was no surprise. Yet the core rate continues to come in above the Fed's comfort zone. This months increase in the core was at 0.2%, the same as last months increase. Combined with previous increases, the core CPI has increased by 2.9% from a year ago.

Owners equivalent rent (OER) continues to push the core upward. This is due to two factors--the improvement in the rental market as housing slows, and the fall in energy prices since OER is computed net of utilities costs. See macroblog for an excellent discussion. Of course OER held the core low during the housing boom. (Ironic, isn't it?) If the rental market continues to improve and energy prices continue to fall, this effect could be with us well into 2007. Does the fact that the rise in the core can be partly explained by the rise in OER make it less troubling? Perhaps slightly, but be careful not to discount it too much. In the last couple years when OER was holding the core down, the core rate was already at the top end of the Fed's comfort zone. If the current rise in OER is the most important change to affect the core in recent months, then not much has changed. The core was rising at slightly more than a 2% rate for most of last year. If the current trend in OER continues, the core inflation rate could top out above 3%. If a simple back-of-the-envelope calculation suggests that after adjusting for OER's effect the core inflation rate has been up around 2.5% or higher for all of that time, that would still be too much for most.

In short, these numbers don't inspire me to call for a rate cut right now. However, there is an interesting question of whether the FOMC's assessment of risks has changed since the last meeting. Aside from the OER component of core inflation (which we can reasonably expect to rise a bit more--and which is somewhat more predictable), it does appear that the risk of additional inflation may have diminished. But the fact remains that the current level of inflation remains too high in the eyes of many. Facing this fact, will the Fed hold rates at this level for an extended period of time or begin raising them again? Given the suggest of "opportunistic disinflation" a decade ago, it is reasonable to expect that they might try that strategy again and hold steady for a while.

Today's CPI figures do not totally clear up the fog of uncertainties. They reinforce the fact that this is still a critical time for the economy. Given the "wait-and-see" stance of the Fed currently, I think it will take more than this to move them off of that position. Will core inflation rates on the wrong side of 3% be enough to effect a change in policy? We may find out.

(Archived BLS press release of today's CPI report)

Harry Truman wanted a one-armed economist. He didn't like our tendency to say, "on the other hand...".

These numbers make it hard to be one-armed. Let's turn it over to Reuters...

WASHINGTON (Reuters) - U.S. producer prices fell more than twice as much as expected last month on a record drop in gasoline prices, but core prices jumped amid a rebound in autos that may vex the Federal Reserve as it weighs inflation risks.

The Labor Department said on Tuesday that producer prices declined 1.3 percent in September, the steepest drop since April 2003. This came with a 22.2 percent fall in gasoline prices that broke the previous record of a 22.1 percent drop, set in March 1986.

It should be obvious that the decline in gas prices is responsible for most of the decrease. So we look at the core PPI. Brace yourself...

The core producer price index, which strips out volatile food and energy costs, advanced 0.6 percent after a 3.5 percent rebound in light motor truck prices, the largest increase since October 1985, following a 3.4 percent dip the previous month.

Passenger cars rose 2.8 percent -- the largest gain in 16 years -- after falling 2.6 percent in August.

Stripping out those sharp rises in truck and car prices, core producer prices would have risen 0.1 percent, a Labor Department official said.

So now the picture is either murkier or clearer depending on the importance you put on the core and various components of the core.

U.S. stock futures and Treasury bond prices lost ground on news of the advance in core prices, while the dollar was little changed.

"It's mostly a rebound in motor vehicle prices that exaggerated the jump in the core," said Mark Vitner, senior economist at Wachovia Securities in Charlotte, North Carolina.

"The trend is still one of moderation and with economic growth slowing, we should inflation moderating further later this year. This doesn't mean that we are not going to see a troubling number from time to time," he said.

Wall Street economists had expected the report, which comes a week ahead of a Federal Reserve meeting on interest rates, to show overall producer prices declining 0.6 percent last month while core prices were forecast to rise 0.2 percent.

So they didn't see the change in auto prices coming.

Financial markets believe the U.S. central bank will hold interest rates steady not just at its October 24-25 meeting, but through the end of the year. But the mixed signals from producer prices underline the tricky task facing policy-makers.

"I think the Fed will be confused on the number but I think the market is looking at the 0.6 (percent rise in core prices) and saying the Fed is less likely to cut," said Robert Macintosh, chief economist at Eaton Vance Management in Boston.

Wasn't the probability of a cut almost zero already? (Was that a Freudian slip revealing his wishful thinking?) This doesn't change much, and it is not going to "confuse" the Fed. The fact that gas prices dropped last month--something that all of us watched happen and so knew would be reflected in the data--certainly will not make them more likely to cut. Core PPI rose more than expected because of autos but without factoring in autos the increase was much more subdued. But when you look at the increase in the core over the last two months, you see that because of the drop in core prices (again due to autos) of -0.4% in August the total increase in the last two months is about +0.2%. That is certainly tolerable.

Far from making the Fed "confused", I think this is a reassurance that last months drop was the anomaly. The core PPI data hasn't changed dramatically since mid-summer. If anything, maybe it is a bit better. Steady as she goes. I can't see how this report is enough to swing the policy recommendation either way. So the stock market is probably overreacting a bit. They'll figure it out soon enough. They usually do. Of course there might be a little latent anxiety in the market in advance of the CPI data tomorrow. We shall see if the headline number and the core go off in opposite directions again. Given the fall in gas prices, I think it's a safe bet. The numbers will be mixed. What else is new?

The September PPI and CPI come out tomorrow and Wednesday, respectively. Housing starts and the MBI refinancing index also are released on Wednesday. Initial jobless claims and the Conference Board leading indicators come out on Thursday.

This is an important week for data out in front of the FOMC meeting taking place on October 24-25. Fed speak will quiet down as the data releases take center stage. St. Louis Fed President Poole indicates that he will be watching the data this week.

"If it looks like the numbers this week and other information suggest to us that the inflation rate is moving higher, or in danger of hanging here ... then I am certainly very much in the camp that would favor additional policy restraint," Poole said in answer to questions after a speech.

Via Reuters.

Minutes of the September meeting are on the Federal Reserve website.

Highlights:

The decline in real state does not appear to be affecting spending, but it is still a concern.

Thus far, the drop in housing market activity appeared not to have spilled over significantly to other sectors of the economy. Indeed, consumer expenditures appeared to have been expanding moderately over the previous few months, buoyed by increases in employment, personal income, and household wealth. Contacts in some Districts reported that retail sales had picked up a little most recently. Meeting participants noted that consumer spending going forward would be supported by the higher levels of personal income indicated by recent revisions to the national income and product accounts, by further gains in employment, and by the decline in consumer energy prices over recent months. However, considerable uncertainty was expressed regarding the ultimate extent of the downturn in the housing sector and the degree to which the slowing in housing activity and the deceleration in home prices would affect consumption and other expenditures going forward.

Inflation seems to be weighing heavily on many of the FOMC members. Some even worry that the public could lose confidence in the Fed's commitment to fighting inflation if the core measure remains at current levels. This is a decidedly stronger statement than at the August meeting.

Many meeting participants emphasized that they continued to be quite concerned about the outlook for inflation. Recent rates of core inflation, if they persisted, were seen as higher than consistent with price stability, and participants underscored the importance of ensuring a moderation in inflation. To be sure, very recent data on inflation suggested some improvement from the situation in the late spring, partly reflecting slower increases in owners' equivalent rent. Also, the considerably lower level of energy prices of recent weeks, if sustained, would help reduce overall inflation and damp increases in core prices. Moreover, businesses would meet more resistance to attempts to pass through cost increases in the less robust economic circumstances that were likely to prevail at least for a time. However, energy prices remained quite sensitive to a wide range of forces, including geopolitical developments, and might well rebound. To date, the available evidence indicated that inflation expectations remained contained--indeed, expectations of price increases for the next few years had fallen some as energy prices declined. Nonetheless, several participants worried that inflation expectations could rise and the Federal Reserve's willingness to carry through on its intention to seek price stability could be called into question if cost and price pressures mounted or even if there was no moderation in core inflation. Looking forward, most participants thought that the most likely outcome was a reduction in inflation pressures, but the anticipated decline was only gradual and the uncertainties around that forecast were skewed toward higher rather than lower inflation rates.

Their decision in September was not as difficult as it was in August.

In the Committee's discussion of monetary policy for the intermeeting period, nearly all members favored keeping the target federal funds rate at 5-1/4 percent at this meeting. Members generally expected economic activity to expand at a pace below the rate of growth of potential output in the near term before strengthening some over time. Moreover, given the uncertainties in forecasting, significantly more sluggish performance than anticipated could not be entirely ruled out. Although the uncertainties were substantial, core inflation seemed most likely to ebb gradually from its elevated level, in part owing to the waning effects of past increases in energy prices. The anticipated expansion of economic activity at a pace slightly below the rate of growth of the economy's potential would likely also play a role by easing pressures on resources. Members noted that certain developments of late--appreciable declines in energy prices, some softer indicators of economic activity, and slightly lower readings on core inflation--pointed to a modestly better inflation outlook and hence made the policy decision today somewhat less difficult than it was in August, when it was seen as a particularly close call.

And yet they make it clear that inflation surprises will be dealt with.

In view of the most recent information on the economy, members agreed that it was appropriate for the post-meeting statement to characterize economic growth as apparently continuing to moderate. However, in view of still-high energy and other commodity prices and elevated rates of resource utilization as well as recent indications of a possible acceleration in labor costs, members continued to see a substantial risk that inflation would not decline as anticipated by the Committee. Consequently, the Committee agreed that the statement should again cite such risks to inflation and explicitly reference the possibility of additional policy firming.

Contrast this with the corresponding paragraph from the August minutes:

All members agreed that the statement to be released after the meeting should convey that inflation risks remained dominant and that consequently keeping policy unchanged at this meeting did not necessarily mark the end of the tightening cycle. They concurred that an indication that economic growth had moderated was appropriate, and a consensus favored citing the same reasons for that moderation as in the June statement. Members also agreed that the statement should both mention factors contributing to the likely moderation of inflation pressures over time and reiterate the forces that were seen as having the potential to sustain inflation pressures.

The last couple sentences of the are a little stronger in the current minutes than in the previous.

Mr. Lacker's reason for dissent remained essentially unchanged.

Mr. Lacker dissented because he believed that further tightening was needed to bring inflation down more rapidly than would be the case if the policy rate were kept unchanged. Recent data indicated that inflation remained above levels consistent with price stability. Moreover, the upswing in compensation and unit labor costs in the first half of the year indicated that inflation risks were tilted to the upside. Although real growth was likely to be moderate in coming quarters, in his view it was unlikely to be slow enough to bring core inflation down.

While it is somewhat ironic that some of the statements about inflation are stronger this time than six weeks ago, we must remember that the last minutes needed to make the case for changing the policy stance from tightening to neutral. Now that the Fed is in a more neutral stance, the communications groundwork needs to be laid for the more likely change in the policy stance. As such it would appear that the next meeting will likely yield no change, but if you were expecting a decrease in rates in the next few months you may be disappointed.

UPDATE: Wall Street Journal and Reuters have articles on the minutes. Reuters characterizes the minutes as hawkish.

UPDATE 2: The NY Times has a quote from Mr. Lacker:

In Washington today, Mr. Lacker expanded on the reasons for his dissent, saying in a speech to the District of Columbia Chamber of Commerce that he is worried that Americans will come to accept higher inflation as the rule rather than an exception, and would act accordingly, to ill effect on the economy.

“If the Fed were to allow inflation to remain above target for too long, inflation expectations could become centered around the higher rate,” he said. “We don’t have any perfect measures of inflation expectations, but what we do have suggests that market participants do not foresee a rapid fall in core inflation. That is why I have argued for further policy actions to convincingly restore price stability.”

His entire speech can be found here, and this is the whole paragraph from which the Times quotes:

Moreover, the longer inflation remains elevated, the more difficult it will be to bring it back down. As people observe actual core inflation of 2.5 percent, along with the FOMC’s reactions, they adjust expectations regarding future inflation, and those expectations become the basis for price setting in product and labor markets. (By the way, it was for his contributions to economic research on exactly this phenomenon that Professor Edmund Phelps was awarded the Nobel Prize in economics a few days ago.) If the Fed were to allow inflation to remain above target for too long, inflation expectations could become centered around the higher rate. Once that occurs, history tells us that strong and more costly policy actions would be needed to bring inflation and inflation expectations back down. We don’t have any perfect measures of inflation expectations, but what we do have suggests that market participants do not foresee a rapid fall in core inflation. This is why I have argued for further policy actions to convincingly restore price stability.

Subtitle: One nasty little shock away from recession (thank goodness)

First, look at Tim Duy's take at Economist's View. Solid analysis and a couple of great lines worth quoting.

Are Fed officials just clueless? Don't they see that the end is coming? I think not – I bet Fed officials are not working overtime to spin a negative story out of every number...

and

If you forced the Fed to choose between cutting rates and hiking rates, they would choose the latter. Luckily, they can choose to pause as well.

I agree. Talk of recession is everywhere. A data point that comes in with slower growth, but growth nonetheless (the ol' "increasing at a decreasing rate" as I like to tell my macro classes) leads some to put on sackcloth and ashes. One certainly has to look at the broader picture, as James Hamilton has done, for example.

Yes, the point is often made that the Fed's record at producing a soft landing is a bit weak, with the only real success being in the mid '90s. Some say that overtightening in the late '80s brought on the 1990-91 recession. I agree that it was certainly a contributing factor. But that makes them 1 for 3 in the last 20 years (2001 being the other negative result). But I'm not sure that I'd look at the scenarios of the 1970s or the early 1980s as being similar enough to that of the last 10 years to want to make the comparison. Could Chairman Volker have managed a soft landing instead of a recession with the lousy deck of cards that he was dealt? Bernanke isn't sitting on a royal flush, but by the same token this clearly isn't 1979.

Whether or not a recession occurs is probably going to be due less to Bernanke's skill or lack thereof than it will be due to whether or not some additional exogenous shock hits the U.S. or world economy. I don't think I'm alone in saying that despite my overall optimism, I am not at all squeamish about saying that we are one nasty little shock away from a recession.

And that brings us to the news of today. Here, CNN channels Reuters:

NEW YORK (Reuters) -- The Thai baht staged its largest one-day fall in three years Tuesday after Thai armed forces ousted the prime minister, sparking a broad decline in a number of Asian currencies.

...

Prime Minister Thaksin Shinawatra, who was in New York to speak at the United Nations, declared a "severe state of emergency" in a broadcast on Thai television.

Looking ahead, the market will watch to see whether the Thai crisis prompts investors to abandon other risky emerging market trades.

The dollar would be the main beneficiary in such a scenario, said Divyang Shah, strategist at IDEAGlobal in London, as it is "not only a high-yielder but is also an attractive safe haven."

But other market participants said solid economic fundamentals in Thailand and other emerging Asian markets make a mass rush for the door unlikely.

"There's been an immediate reaction and people will move to the sidelines to see how it all unfolds, but what we'll see will probably be a short-term disruption," said Upadhyaya.

...

Karl Jackson, president of the U.S.-Thailand Business Council, said the country has experienced a military coup 17 times since 1932.

"Basically before democracy came to the forefront, this was the their way of changing the government and it continues," said Jackson, who is also director of Southeast Asia studies at Johns Hopkins University.

"There might be a momentary glitch on the part of investors, but as in previous coups, investment and property rights won't be affected. If the coup is successful, I expect everything will be normal in the morning," he said.

Still, investors were watching the situation closely, since the Asian currency crisis in 1997 started with the devaluation of the Thai baht, then grew into an international economic slowdown.

Yes, it may be that everything will be normal in the morning--except perhaps for Mr. Shinawatra. In all likelihood this will not cause the sort of contagion that took place when the baht collapsed in 1997. But as I read the news coming out of the Asian markets tonight as their trading day comes to a close, I can't help but get the feeling that someone is looking over my shoulder and saying, "Made you look!"

Yes, indeed I looked. Because if there is trouble to be made for the U.S. economy, or the world economy for that matter, it will be made by that unexpected exogenous shock. The straw that broke the camel's back--a classic non-linearity. Maybe not today. Maybe not the baht, but it made me look.

For the last year, I've been cautiously optimistic that we could avoid a hard landing, and to this point it would seem that we have. However the tensions of the last year or two (rising interest rates, rising then falling housing markets, questions about the health of the labor market, etc.) are beginning to give even the optimistic among us a little cause to look over our shoulder once in a while.

Yet, this is something we may have to get used to every decade or so. We have not eliminated the business cycle, but we have tamed it a little. That is going to mean sailing close to the rocks now and then. As long as we keep inflation low and stable, there will be less need for major course corrections. A soft landing, while not assured, is then possible if you are fortunate. It's nerve-racking, but it's better than the boom-and-bust alternative that comes from chasing the Phillips curve too hard.

Thus it is all the more important for the Fed to stick it its inflation fighting guns. As Tim Duy said, given a choice between raising and lowering rates, they would probably raise. That would be my choice as well. But given the increased uncertainty about the effect of the housing slowdown and the lagged effect of past rate increases yet to be felt, keeping rates where they are at this point in time (with a bias toward tightening) is an even better idea. Keeping inflation low and stable is the best thing the Fed can do to ensure that we are one nasty little shock away from a recession more often than we are rushing headlong into one.

After reading the FOMC minutes, I became convinced that it would take a spike in inflation (particularly the core measure) to get the Fed to resume the rate hikes in September. Well let me revise my priors upward once again. Today's inflation figures make it more likely that the Fed will keep rates where they are. But it does little to ease my concern that more increases are on the way in the months ahead. The year-on-year measure is still higher than many would like. The longer it stays that way, the harder it is to get it down (unless you get lucky like we did in the mid-'90s).

So the expectation was for the core to rise by 0.2% and it only rose by 0.1%. Reuters has the story.

WASHINGTON (Reuters) - Core U.S. inflation rose less than expected in July, but the year-over-year pace remained elevated, according to a government report on Thursday that the inflation-wary Federal Reserve will examine.

Core consumer prices rose a less-than-expected 0.1 percent in July, but the year-on-year rate of nonfood, nonenergy inflation remained at 2.4 percent, the highest since September 2002, a Commerce Department report showed.

Analysts polled by Reuters were expecting a 0.2 percent gain in core consumer prices, an indicator that will be a factor in the Fed's decision whether to hold interest rates steady.

For the Federal Reserve "this is another reason to not increase," said Robert MacIntosh, chief economist at Eaton Vance Management in Boston.

Or another reason to go to three decimals as the BLS is doing for the Consumer Price Index. Today's report is on the PCE which, presumably, will remain a one decimal series. (UPDATE: See comments.)

Not that it makes a whole lot of difference in the long run. If there is a lot of rounding down this month, it will just be more likely that it will round higher next month. But it does make one cautious about interpreting the difference between 0.2% and 0.1% in one month's change.

But even if it were a 0.2% in the PCE price index, it probably wouldn't be enough to move rates at this moment in time. The more incoming data we receive, the more it looks like the Fed will simply pause until the recession threat subsides, even if core inflation remains at current levels. They remain committed to preventing further increases in core inflation, but are not rushing towards "disinflation". If we get some relief on energy prices, we might just get lucky, just like in the '90s.

The march of data continues tomorrow with nonfarm payroll employment.

UPDATE: Macroblog links to the Dallas Fed's trimmed mean PCE inflation rate and is not ready to "declare victory" over inflation.

Via Reuters:

Lacker, explaining his decision at the Fed's Aug 8 meeting to break with the majority and vote for a rate increase, told Bloomberg Television: "I dissented because I thought we needed to bring inflation down more rapidly than would otherwise be the case without a move at that meeting."

"The risk of raising rates at that meeting for lower real growth was not appreciable and, moreover, I didn't think real growth moderating -- as it's likely to over the next couple of quarters -- was going, by itself, to bring inflation down," he said. "I think there is a danger of inflation becoming entrenched at the level it is now."

He said that since Fed officials last met, he had seen nothing in the data to change his assessment of the outlook.

In related news, James Hamilton has a different take on the recent data.

Apropos of our discussion on inflation and monetary policy, comes this via Reuters:

On Monday, U.S. crude touched an intraday low of $58.60 a barrel, the weakest level since late July, and prices had also fallen by more than a dollar on Friday.

"We started coming down at the end of August," said Christopher Bellew of Bache Financial in London. "So we've been coming down for about 10 weeks. Oil trends tend to go on for much longer than that, so we have got a continuation of the downward movement, whether on warm weather or on weak demand."

And yet natural gas prices are soaring. I just got my bill and the marginal rate is almost three two and a half times what it was a couple years ago. (UPDATE: To be exact, 48 cents/therm in Jan. 2002; $1.20/therm in Oct. 2005)I don't think there's any doubt that the price is going even higher. No matter what kind of winter we have.

My point? Even if oil prices head towards $40, a lot of us will feel "inflation" from higher energy prices. It's not trivial. It's going to be a rough winter for a lot of people. But there's not much that monetary policy can do about it.

Daniel Gross has the lastest installment in the NY Times:

Prices of food and energy are notoriously volatile, and susceptible to supply shocks and acts of nature. Inflation in these vital sectors doesn't necessarily indicate inflation across the economy. Mr. [Steven] Roach notes that in the last year, consumer energy prices have risen 35 percent, while prices of other goods and services are up just 2 percent.

Economists also say the utility of the inflation measure depends on the question you are trying to answer. "If you want to know how much more it costs you to live this year than last year, look at the headline C.P.I.," said Ann L. Owen, associate professor of economics at Hamilton College in Clinton, N.Y., and a former economist at the Federal Reserve. "And from a consumer's perspective, there's nothing good about a 4.7 percent increase in headline inflation in 12 months."

...

What's more, the Fed tends to focus on things that it can control. Not even a Fed chairman as powerful as Alan Greenspan can affect the price of oil by manipulating interest rates. "There's nothing the central bank can do about that, unless it figures out how to produce more oil," said Michael F. Bryan, vice president and economist at the Federal Reserve Bank of Cleveland.

But the Fed can control the amount of money circulating in the economy relative to the quantity of goods available. "So it tries to find the inflation signal common to all prices throughout the economy," Mr. Bryan said.

Thus considered, the core C.P.I. may be the best tool the Fed has to monitor long-term changes in prices.

Still, economists see two good reasons not to ignore the headline number today. First, inflation in a crucial category like energy can worm its way into the entire system. "If high energy costs persist, and if they continue to rise, they may ultimately seep into the core," Professor Owen said. The second reason has less to do with hard economic realities than with softer perceptions. The cost of gasoline is the economy's most visible price. People see it every day even if they don't buy gas every day, said Matthew Martin, senior economist at Economy.com. And most people buy food every week.

And with this, I inaugurate the "inflation" category on the blog. Previously, inflation had been categorized under "data" or "Federal Reserve" depending on the context. Someday I might even have time to totally overhaul the categories. We'll see.