Recently in Federal Reserve Category

SYDNEY (Reuters) - Australia's central bank raised its key cash rate by 25 basis points to 3.25 percent on Tuesday, as surprising economic strength allowed it to withdraw some of the exceptional stimulus doled out during the global credit crisis.

Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn.  Conditions in financial markets have improved further, and activity in the housing sector has increased.  Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.  Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.  Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.

With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.

In these circumstances, the Federal Reserve will continue to employ a wide range of 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 continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.  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 $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt.  The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010.  As previously announced, the Federal Reserve's purchases of $300 billion of Treasury securities will be completed by the end of October 2009.  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 monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.

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.

OAK BLUFFS, Massachusetts (Reuters) - U.S. President Barack Obama will nominate Ben Bernanke to a second term as chairman of the Federal Reserve on Tuesday as the economy shows signs of recovery, a senior administration official said on Monday.

Bernanke, whose appointment as head of the U.S. central bank must be confirmed by the Senate, has led the Fed and the U.S. economy through its most tumultuous period since the Great Depression of the 1930s. Obama's Democrats control the Senate.

Read the whole article.

Give the president credit for understanding the importance of removing any uncertainty about the outcome of his decision.  I believe it was the right decision.

Information received since the Federal Open Market Committee met in June suggests that economic activity is leveling out. Conditions in financial markets have improved further in recent weeks. Household spending has continued to show signs of stabilizing but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing but are making progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, 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.

The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.

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 continues to anticipate 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 is in the process of buying $300 billion of Treasury securities. To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October. 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 monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.

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.

• No change in the fed funds target
• Fed funds rate will likely remain low for an extended period
• Purchases of Treasury securities that has been announced and ongoing for several months will slow and come to an end by the end of October
• Economy to remain weak for some time, but gradually return to sustainable growth
• Commodity prices rising, but considerable slack suggests that inflation will remain subdued

The plan is built around five key points, according to a briefing last night by senior administration officials and a copy of the white paper obtained by The Washington Post.

The proposals would greatly increase the power of the Federal Reserve, creating stronger and more consistent oversight of the largest financial firms.

It also asks Congress to authorize the government for the first time to dismantle large firms that fall into trouble, avoiding a chaotic collapse that could disrupt the economy.

Federal oversight would be extended to dark corners of the financial markets, imposing new rules on trading in complex derivatives and securities built from mortgage loans.

The government would create a new agency to protect consumers of mortgages, credit cards and other financial products.

My response goes something like this.  We live in an imperfect world with imperfect regulations on financial markets.  Hence, there exist policies that would represent an improvement on the current system, but there are also many (more) ways to mess it up even worse.

It would be much easier if we could close our eyes, make a wish, and eliminate stupidity and dishonesty.  But since that won't happen, let's think about whether the Obama plan would represent an improvement.

Hopefully it would put a stop to the "too big to fail" argument.  Obama seeks to give the government (Fed) the ability to break up large bank holding companies that get into trouble.  But the only part of the white paper where this is directly mentioned (that I can find) is pages 74-76.  To say it is short on details would be charitable.  Granted, this is something where the rules would probably be written on the fly, but then, isn't that what we're doing now?  Is it enough to just say that we'll let the Fed do what it needs to do?  If we did write rules for this, could the end up being too constraining?  This is a really tough problem, and I don't think they've solved it.

On the plus side, the document does spend a few pages suggesting a larger role for the Fed in overseeing the payments, clearing, and settlement systems.  Now that's something that is actually within their proper scope of regulation anyway.  That seems like a winner.  (But also short on details.)

More rules on trade in derivatives is also something that I would support if done right.  I'll need to think more about what is the right way.

But the document also spends a disproportionate amount of pages discussing how to protect consumers from "financial abuse."  In fact, in my perusal of the document tonight, I see the most detail in this section.  Among other things, they would like to mandate that a traditional fixed-rate 30-year mortgage ("plain vanilla" as they put it) be offered alongside any other lawful mortgage products, and that the consumer be given the tools to compare the various products.

Sorry, I don't see this as making much difference.  We already have disclosure requirements that kill quite a few trees for every mortgage closing.  With all of the information shoved in front of the homebuyer, most people just shut up and sign.  Will giving them more information (as opposed to useful knowledge--which cannot just be given) really make a difference?  If you're an unethical mortgage broker, don't you think that there will be a way to game this system to your advantage (offering fixed-rate mortgages at exorbitant interest rates to discourage their use, for example)?

Yet this seems to be where the administration is focusing its efforts.

Fortunately, there was some other insightful comment on regulation today.  Arnold Kling writes in a guest column at the Washington Post:

In my view, the worst regulatory error was allowing bank capital regulations to be evaded. In the late 1980s, after many savings and loans had failed in the United States, international bank regulators developed the Basel capital accord. Although this was flawed in many respects, it did represent a formal requirement for banks to hold capital based on risk. Most assets required 8 percent capital. Some low-risk assets required 4 percent capital, and some government securities required even less.

Soon after the capital accords were rolled out, banks began to come up with ways to "game" the system. For mortgages, the two most important techniques were securitizing mortgages and creating off-balance-sheet vehicles. Securitization allowed banks to get large portions of their mortgage portfolios rated AAA, and these AAA ratings in turn lowered capital requirements, particularly after a revision to the capital requirements that was formalized on Jan. 1, 2002. The off-balance-sheet entities were an even bigger scam, because generally-accepted accounting principles (which the regulators copied) allowed the banks not to count the mortgage securities in these entities as assets at all.

All of this was done right under the nose of the regulators. An article in 2000 in the Journal of Banking and Finance,called "Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues," was written by a Federal Reserve staffer. Although such scholarly articles always carry disclaimers that the contents do not represent the opinions of the Fed, it clearly showed an awareness of how banks were using techniques to evade capital requirements. The author rationalizes this in part by suggesting that without the ability to evade capital requirements, banks would have been less competitive in the market to finance mortgage loans or other low-risk assets.

I think Kling is on the right track.  If financial market regulation is like firefighting, then to prevent this sort of gaming of the system would be like starving the fire of fuel.  A different tactic than pouring water on the fire, but still effective--sometimes more so.

At Marginal Revolution, Tyler Cowen writes:

The broader point is this.  Better regulation comes through many years of experience and gradual process improvements, built upon some reasonable methods for imposing regulatory accountability.  That's how the FDIC got to be good at much of what it does.  Better regulation does not come from sitting down, waving a wand, and hoping that a new name or box will address the problem you are concerned about.  Keep that in mind next time you hear that "now is the unique moment," etc.

Well put.  Doubling or tripling the amount of paper shoved in front of a home buyer at closing won't do it either.  There should be changes.  But there really isn't any need to rush something through by the end of the year. We're not in danger of a repeat of the circumstances that laid the groundwork for the crisis any time soon.  So take some time and do it right.  There might be a few good ideas in the Obama plan, but there is also a lot more alphabet soup without a lot of details about how it will all work.

Felix Salmon calls it a bust as well.

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.

I am happy to report that macroblog is back. David Altig, who had been running the blog independently since 2004 when he was at the Cleveland Fed, has brought back the blog with a new look and some new co-authors. Altig, now research director at the Atlanta Fed, is bringing the other Atlanta economists into the blogosphere as co-authors on macroblog.

Welcome back, David, and thanks for making macroblog part of the research mission of the Atlanta Fed.

The Chicago Fed also has a blog (three, in fact). Are there others I'm not aware of? Are the other Feds listening?

It's probably a good thing that the determination of a recession is not subject to a majority vote.

Via Reuters:

NEW YORK (Reuters) - Just over two-thirds of Americans believe the country is either already in recession or headed for one over the coming year, according to a new poll conducted jointly by The Wall Street Journal and NBC.

Nearly half the survey respondents, 46 percent, believed a recession was already under way.

The conviction comes despite a 3.4 percent rebound in economic growth during the second quarter, according to Commerce Department data released last week.

A recession is generally defined as two consecutive quarters of declines in gross domestic product.

Turning points in the economy are notoriously difficult to predict. In 2001, many Wall Street and government forecasters waited until growth had already turned negative before acknowledging a period of contraction.

Can we lose the definition of "two consecutive quarters of declines in GDP"? By that definition, we didn't have one in 2001. What we had was three quarters of negative growth, but they were every other quarter. One down, one up... one down, one up.... one down, one up. Definitely a recession, there's no question about that. But the standard textbook definition is obsolete.

Likewise, even though the most recent quarter posted growth above 3% doesn't mean that this is a trouble-free economy. Just about everyone acknowledges that growth for the rest of 2007 will be weaker, perhaps significantly weaker. If we have two quarters of growth around 1%, will it feel like a recession? Perhaps in many ways, yes. Would it meet the textbook definition? No.

This is not your father's economy, and the textbook definitions that worked in the '70s and '80s to explain the malaise of the time are not applicable now. We need to get out there and educate the next generation as to the subtleties of economic statistics, lest they become disillusioned that economists and the media are out of touch with their textbook definitions from the '70s.

At least we don't wear bell-bottoms.

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.

That is to say, it's easy over very short time horizons and almost impossible over longer horizons. In Monday's Wall Street Journal, E.S. Browning continues the chronicle of the widening disconnect between the Fed and the market.

The Fed is expected to leave target interest rates unchanged, fueling hopes that it will start cutting rates some time next year, which would be good news for stocks and bonds.

But worries are spreading that, longer-term, investor hopes for interest rates may have gotten a little out of hand. If so, stocks and bonds both could be in for some rough waters in the coming months.

Later in the article, his interview subject expresses thoughts that should be familiar to any reader of this blog.

"Inflation is the key here," says Ethan Harris, chief U.S. economist at Lehman Brothers. "Inflation is the enemy of all markets. If you get serious inflation, if the Fed's fears materialize, then you will have the Fed hiking instead of cutting, pushing growth weaker. That is a lousy environment for both" the stock and bond markets.

Mr. Harris isn't forecasting a resurgence in inflation. He thinks it could remain more or less steady.

But, like the Fed, he doesn't think that is a sure thing, and he thinks investors could be making a mistake to assume that inflation is dying....

Sorry. No "one armed economists" here. On the one hand inflation could be under control. On the other hand the battle may not yet be over.

Some people find a certain irony in all this.

Now, Mr. [Jim] Bianco [of Bianco Research in Chicago] notes, "the guy that is holding the Fed back from easing is Helicopter Ben. We got him all wrong, at least for his first 10 months" in office.

It is really hard not to say, "I told you so."

Anyway, while we sit here and think about the implications of what the Fed may or may not do, Ed Prescott reminds us in a Wall Street Journal op-ed today that it may not matter all that much. The op-ed is titled "Five Macroeconomic Myths" and is sure to provoke a response from people who, for example, think that the national debt is too large (it's #4 on his list). Read the whole thing. Here's part of myth #1 that monetary policy causes booms and busts.

Between 1975 and 1980, the inflation-corrected federal funds rate was low; at the same time, output trended upward until late 1978. So far, things look somewhat promising for the mythmakers. But looking closer at the data we see that output began its downward trend in late 1979 while monetary policy was still easy through most of 1980. Also, output continued its decline through 1982, when it began to climb at a time when monetary policy remained tight.

These facts do not square with conventional wisdom. Our obsession with monetary policy in the conduct of the real economy is misplaced.

Where monetary policy's effect on output is concerned, expectations matter. That is a fact which is not lost on Mr. Bernanke, especially these days.

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.

Maybe. (NY Times)

The Labor Department said that unit labor costs, a measure of what workers earn that takes into account their productivity, rose 2.3 percent in the third quarter, falling short of the preliminary estimate of 3.8 percent issued last month. Worker productivity increased 0.2 percent in the third quarter, more than the government’s first calculation of no change but far less than the productivity gains during the first half of the year.

Strong productivity is needed to help offset growing labor costs so they do not feed into inflation. In that sense, some economists noted that the 0.2 increase in productivity growth was troublesome.

A decline in productivity growth would mean somewhat tighter monetary policy would be warranted, all other things being equal. Let's go to Bernanke's speech from last week:

That said, longer-run trends in the growth of productivity are very difficult to predict. During the first half of the decade, productivity in the nonfarm business sector increased at an unusually high average annual rate of about 3 percent. However, according to current estimates, productivity growth slowed in the second quarter of this year and came to a halt in the third quarter. Moreover, the strength of recent hiring raises the possibility of subpar productivity growth in the fourth quarter as well. When all is said and done, however, I expect that the latest numbers will turn out to have been a reflection of the typical volatility in the data and some cyclical response to the slowing in economic activity, not a signal of a sea change in the longer-run outlook for productivity growth.

Even if productivity growth is sustained at a reasonably good rate, the slower expansion of the labor force will imply some moderation in the rate of growth of potential output over the next few years. In the very near term, that slower growth in the labor force needs to be taken into consideration when assessing the sustainability of given rates of expansion in economic activity. In the medium term, because the factors that affect potential output and thus aggregate supply also tend to affect aggregate demand, slower growth of potential output does not necessarily mean that inflation will be higher or that monetary policy will have to be tighter. Rather, the implications for monetary policy of a possible slowing in the growth of potential output depend on the extent to which such a slowing alters the balance of supply and demand in the economy. For example, as we saw in the second half of the 1990s, changes in expected productivity growth and potential output can significantly affect aggregate demand through their influences on income expectations and asset prices. The problem for policymakers is to identify, in real time, any changes in the prospective growth rate of potential output and to anticipate the accompanying effects on the balance of supply and demand.

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. Will next week's statement be more hawkish? Or will they admit that the slowing economy may necessitate easing? How would the latter be interpreted?

The October minutes are on the Fed's web site. Here's the first thing that caught my eye.

The Chairman noted that the President had recently signed the Financial Services Regulatory Relief Act of 2006, which among its provisions gave the Federal Reserve discretion, beginning October 2011, both to pay interest on reserve balances and to reduce further or eliminate reserve requirements. The Act potentially has important implications for many aspects of the Federal Reserve's operations and the Chairman asked Vincent Reinhart, Director of the Division of Monetary Affairs, to form a committee of Federal Reserve System staff to consider these issues.

They could learn from Canada, the UK, and New Zealand, as this publication by Sellon and Weiner from the Kansas City Fed explains. Let me know if you have other papers in this area to suggest.

On to the current outlook,

In their discussion of the economic situation and outlook, meeting participants noted that incoming data over the relatively brief intermeeting period had come in broadly as anticipated. The most recent indicators suggested that economic growth had probably slowed more sharply in the third quarter than had been expected at the time of the September meeting, but that appeared to largely reflect the impact of temporary influences. Participants continued to expect the economy to expand at a rate close to or a little below the economy's long-run sustainable pace over coming quarters. The ongoing adjustment in the housing market was likely to depress real activity in the near term, but this effect was expected to wane gradually; private final domestic purchases had held up well in recent months and looked set to expand at a reasonably good pace. Although recent monthly inflation readings indicated some slowing of core inflation from the very rapid rates of spring and early summer, many participants noted that current rates of core inflation remained undesirably high. Most participants expected core inflation to moderate gradually, but they were quite uncertain as to the likely pace and extent of that moderation.

There was some concern about consumer spending, especially if the housing market continues to falter.

To date, weakness in the housing market and the associated downshift in house price appreciation did not seem to be spilling over into consumer spending, which appeared to have grown at a steady pace in recent months. Retail activity in most Districts had been relatively robust and contacts in the retail sector were generally upbeat about the outlook. Several participants noted, however, that contacts within the transportation sector had reported that activity in anticipation of the holiday shopping season appeared to be softer than in previous years. Meeting participants judged that consumer expenditures going forward were likely to expand at a steady pace a little below the growth in disposable income, supported by favorable financial conditions, continued increases in employment and income, and the recent decline in energy prices. Nonetheless, many participants expressed concern that ongoing developments in the housing market could have a more pronounced impact on consumer and other spending, especially if house prices declined significantly.

Inflation, however, appeared to be more of a concern, even in light of lower energy prices recently. The main concern is that if core inflation is too high for too long it will cause expectations shift.

All meeting participants expressed concern about the outlook for inflation. Most participants expected core inflation to edge lower, in part as the effects of the run-up in energy prices in recent years waned. And shelter costs were not expected to add materially to inflation going forward. Moreover, moderate growth in aggregate demand and the associated modest easing of pressures on resource utilization should also contribute slightly to the slowing in core inflation. Recent changes in core prices had declined slightly from earlier in the year. Nonetheless, nearly all participants viewed the current rates of core inflation as uncomfortably high and stressed the importance of further moderation. The available measures suggested that medium- and long-term inflation expectations remained around the levels seen for the past several years, although in the view of some participants these expectations were probably higher than would be consistent with their assessment of long-run price stability. Participants were concerned that inflation expectations could begin to drift upwards if core inflation remained elevated for a protracted period. Any such rise in inflation expectations and associated upward pressure on inflation itself would likely prove costly to reverse. Although some participants noted that the recent slowing in core inflation had helped to allay their fears of a further sustained increase in inflation, all participants emphasized that the risks around the desired downward path to inflation remained to the upside.

In summary,

...Although substantial uncertainty continued to attend that outlook, most members judged that the downside risks to economic activity had diminished a little, and likewise, some members felt that the upside risks to inflation had declined, albeit only slightly. All members agreed that the risks to achieving the anticipated reduction in inflation remained of greatest concern. Members noted that a significant amount of data would be published before the next Committee meeting in December, giving the Committee ample scope to refine its assessment of the economic outlook before judging whether any additional firming was needed to address those risks.

Overall, the data coming in over the last few days has given me no reason to expect any additional firming is coming in December. Many have been speculating that the Fed may ease rather than tighten in early 2007. I'm not on that bandwagon yet, but I'm less dismissive of it than I would have been two months ago. It seems that staying the course is the best bet, probably for another meeting or two before we see where things are heading. I have been somewhat sympathetic with Mr. Lacker for worrying that core inflation has been too high for too long and thus additional firming will be necessary sooner or later. Depending on tomorrow's CPI, I maybe more or less so. I'm leaning toward the "less". If the core CPI (and then later the more important core PCE) are moderating, then it seems a good bet to hold things where they are. We shall see.

On communication, they had this to say...

The Committee then continued its discussion of communication issues and considered the advantages and disadvantages of quantifying an inflation objective. Participants stressed that any such step had to be consistent with the statutory objectives for monetary policy. In that regard, it was noted that over time price stability is a prerequisite for maximum employment and moderate long-term interest rates. However, the possible specification of a numerical price objective raised a number of complex and interrelated issues that required considerable further discussion. The Committee reached no decisions on these issues at this meeting, and participants agreed to continue the Committee's review of communication issues at its meeting in January 2007.

Check 21 is the name given to the law that allows banks to treat the image of a check as the real thing. Transmission of the images saves time and money, and it allows checks to clear even in the event of another 9/11 type of crisis that cripples the nation's transportation system (most checks travel in the bellies of airplanes).

Large banks started clearing checks electronically almost immediately after the law was passed. Now, as the NY Times reports, small businesses are able to take advantage of the efficiency improvement. The necessary hardware is available for about the price of a personal computer ($500-$1200).

Now banks are issuing miniature versions of those scanners to their small-business customers. The Stone Age, a 10-person company that sells stones, bricks, statues and tools to landscapers, started scanning its checks for deposit a few months ago. One of its owners, Jack Longo, estimates that it saves him five hours a week that used to be spent driving to and from the PNC branch about 10 miles away from his office in Totowa, N.J.

Mr. Longo had to go to the bank only twice in August: once because he had a check, for $50,000, that exceeded the dollar limit for remote deposit, and another time because he needed to initiate wire transfers that could be handled only at the branch.

Adding to the benefits, the device — a single-feed scanner made by the RDM Corporation — is connected to the company’s QuickBooks accounting software. After both sides of a check are scanned, the device’s software reads the routing number and dollar value and creates an electronic deposit slip. It also updates the company’s account balances and its accounts-receivable log.

“The computer automatically debits and credits the proper things, and all the bookkeeping is done at that time,” Mr. Longo said. That saves him money on the outside bookkeeper he pays by the hour. The scanner almost never reads the numbers wrong, he added, whereas “manually, you are prone to transposition or entering the wrong amount.”

Instructors who teach principles of macroeconomics are often discussing money and banking at about this time of the semester. This would be an interesting article for your classes and could be used as a starting point for a discussion of check clearing, the banking system, and the Fed.

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.

Link to the statement:

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.

Economic growth has slowed over the course of the year, partly reflecting a cooling of the housing market. Going forward, the economy seems likely to expand at a moderate pace.

Readings on core inflation have been elevated, and the high level of resource utilization has the potential to sustain inflation pressures. However, inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions and other factors restraining aggregate demand.

Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; William Poole; Kevin M. Warsh; and Janet L. Yellen. Voting against was Jeffrey M. Lacker, who preferred an increase of 25 basis points in the federal funds rate target at this meeting.

Differences between this statement and the last are actually very few, and do help clarify rather than obscure what the FOMC is and has been thinking.

Here is a link to the previous statement. Notice that the verb tense has changed in the paragraph on growth.

The moderation in economic growth appears to be continuing, partly reflecting a cooling of the housing market.

Previously it was stated that the moderation in growth appears to be continuing. Now they say that growth "has slowed" and add a forward looking statement that growth is likely to expand at a moderate pace.

Soft landing, anyone?

The paragraph on inflation is revised and is more clear than in the previous statement. In September it read,

Readings on core inflation have been elevated, and the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures. However, inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions and other factors restraining aggregate demand.

When the previous statement came out, Tim Duy was not impressed. To me it looked like they were hedging on energy prices--not yet ready to let go of the line about energy prices adding to inflation pressures. That part is now gone. As a result, the statement is a lot crisper. That is really the only substantive change. The focus now is on the possibility that resource utilization is the main worry for any further inflation going forward.

The statement about inflation risks remaining is identical to what we have seen before. The fact that Mr. Lacker dissented again indicates that among those who think inflation is already too high nothing has fundamentally changed. This is not the kind of statement that makes you think that a rate cut is around the corner. On the contrary, if this is a soft landing, some futher firming of policy will probably be needed to bring inflation down from its current level.

Today's statement is clearer than the last, and that is a good thing. The debate over whether or not we are in the midst of experiencing a soft landing will continue.

Via Reuters:

The Labor Department said a seasonally adjusted 299,000 workers filed new claims for state unemployment insurance benefits in the week ended October 14, down from 309,000 claims a week earlier.

Economists polled by Reuters were expecting a slight increase in jobless claims to 312,000 from an original reading of 308,000 in the week ended October 7.

Separately, the Conference Board released its index of leading economic indicators today. From their website:

The Conference Board announced today that the U.S. leading index increased 0.1 percent, the coincident index remained unchanged and the lagging index increased 0.2 percent in September.

and...

The leading index has fallen 1.0 percent below its most recent high reached in January. At the same time, real GDP growth slowed to a 2.6 percent (annual) rate in the second quarter, following a 5.6 percent gain in the first quarter. The behavior of the leading index so far suggests that economic growth should continue at the slow rate in the near term.

According to the Wall Street Journal, analysts had expected a 0.3% increase in the leading economic indicators. So once again the news is mixed. Overall, it appears that the economy is slowing a bit. Growth for the remainder of the year will probably remain below average, but there is no indication yet of a full-blown recession.

Taken as a whole, this week's data releases leave us pretty much where we started. If there were only a couple pieces of conflicting evidence, it would be more puzzling. The preponderance of conflicting signals reinforces what most of us have been thinking for a while. For the past few months, indeed most of this year, the economy has been slowly inching toward a critical point where either growth will slow (perhaps briefly turning negative) or resume at a more normal pace. That's a good argument for not doing anything to rock the boat at the moment.

UPDATE: On Tuesday, I admitted that the mixed bag of data makes it impossible for me to be Harry Truman's "one-armed economist". Today, James Hamilton also cannot avoid saying "on the other hand."

I'm wondering though whether "no change" might be the least likely outcome at this point. If we start to see some serious financial repercussions develop in housing, I'd look for a rate cut, and wouldn't worry in that event about commodity prices, since I would expect to see commodities fall sharply on news of a big downturn in economic activity. On the other hand, if instead we have seen the bottom for housing and the core inflation numbers remain this high, I'd look for the Fed to tighten further.

That is the direction the data has been pushing me as well. Unlike Kash, who seems more convinced than I that we've reached a peak (though he does leave some room for doubt), I see the upside and downside risks as roughly equal.

It might be that the upcoming 3rd quarter GDP data could be the news that gives us a clue as to which way this will break. It probably won't be the overall growth rate (which is likely to be positive but below everage), but the different subcategories of consumption and investment that will tell the story. At least until that point, I'm prepared to use both hands when explaining where the economy seems to be going, and what direction interest rates might take in 2007.

UPDATE 2: David Altig finds himself in general agreement and is almost ready to take the next step--but not quite.

But, for reasons I'll detail in a later post, I'm beginning to wonder about the reach of developments in [the housing] sector. I'm not quite ready to take the anti-Roubini bet with the degree of confidence that Nouriel himself puts on his recession call. But I'm getting there.

Absent any additional negative shocks, I would agree. I'm not quite ready to call it a soft landing yet, but I too am getting there.

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?

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.

In today's NY Times, Joseph Stiglitz takes on the topic of the hour. Most of it you have probably heard elsewhere. This part is not always mentioned:

Imagine that the Bush administration suddenly got religion (at least, the religion of fiscal responsibility) and cut expenditures. Assume that raising taxes is unlikely for an administration that has been arguing for further tax cuts. The expenditure cuts by themselves would lead to a weakening of the American and global economy. The Federal Reserve might try to offset this by lowering interest rates, and this might protect the American economy — by encouraging debt-ridden American households to try to take even more money out of their home-equity loans to pay for spending. But that would make America’s future even more precarious.

Yes, there is a tension between the fiscal and monetary authorities in cases like this. That is an important point to make, and is not always made. Stiglitz has a simple solution, however.

There is one way out of this seeming impasse: expenditure cuts combined with an increase in taxes on upper-income Americans and a reduction in taxes on lower-income Americans. The expenditure cuts would, of course, by themselves reduce spending, but because poor individuals consume a larger fraction of their income than the rich, the “switch” in taxes would, by itself, increase spending. If appropriately designed, such a combination could simultaneously sustain the American economy and reduce the deficit.

"If appropriately designed...," is a deus ex machina. This paragraph, I think even the most adamant proponents of tax increases would admit, makes a number of assumptions. One important one would be that the increase in taxes at the high end of the distribution does not reduce saving even further (since he laments our lack of savings earlier in the piece). It also assumes that the tax change would cause enough new spending by "poor individuals" to offset whatever change in consumption and savings occurs at the high end. I suppose one could postulate a Keynesian model and mathematically determine how to change taxes at different income levels--thus the phrase "if appropriately designed". I am understandably skeptical of either party's ability to do the math and appropriately design the new policy. I would also apply the Lucas Critique to any proposed model.

So the title of the piece, "How to Fix the Global Economy," is perhaps too ambitious. It's not that simple, even at the textbook level. Unfortunately, it is hard to fix the global economy in 1000 words--harder still when you have to expend half of your word budget rehashing the yuan issue. He makes an excellent point on the fiscal vs. monetary conflict but reduces the solution to one paragraph that raises more questions than it answers and makes some rather heroic assumptions about our ability to model the effects of these policies as well as our ability to design and implement them. The debate continues.

UPDATE: The debate does indeed continue. Mark Thoma, Greg Mankiw, and "knzn" all weigh in. Thoma notes that it is the difference in maginal propensities to consume (for individuals with different levels of income) that matters. True. Mankiw argues that average propensities differ, but that "...the evidence for substantially different marginal propensities is much weaker." Being charitable and granting the benefit of the doubt that there may be some difference in MPCs, I'm still left with the feeling that those MPCs (and the differences between them) are not policy-invariant (my original objection invoking the Lucas Critique). I would be very wary of attempts to fine tune progressivity to this objective. If you want to argue for more progressivity for other purposes, that's one thing. But this argument doesn't convince me. (Greg Mankiw makes a similar statement.)

Postscript: In this post, I referred to posulating a Keynesian model. That is not to say that I think that a Keynesian model would be the one I would opt for in addressing this issue, but because it seemed to best fit the argument that Stiglitz was making (the focus on the MPC in formulating tax policy). Just wanted to clarify that.

Tim Duy is not impressed.

OK, so they don’t completely know which way the economy is headed; not entirely unexpected, given that the US economy is almost certainly at an inflection point (although I like to see a bit more confidence from my central bankers, or at least another explanatory sentence). But I would expect the Fed to have a better handle on the inflation situation. Unfortunately, the third paragraph doesn’t leave me very confident on that front either. In the first sentence, energy prices have the “potential to sustain inflation pressures.” In the second sentence, inflation pressures are likely to moderate due to the “reduced impetus from energy prices.” What? WHAT!?! Are energy prices contributing to inflation or not? Shouldn’t the FOMC have an opinion on the impact of energy prices on inflation?

He's got a point. My reading of it was that they moved one of the statements about energy prices from the 2nd to the 3rd paragraph to reflect their thinking that energy prices are more likely to moderate and thus help us out on the inflation front rather than hurt us on the growth front. The line that energy prices have the potential to sustain inflationary pressures could be seen as a hedge. But that would beg the question of whether the press release is an appropriate place to hedge. I'm with Tim on that.

He also says,

In any event, this mixed message stuff is not exactly credibility enhancing.

I'll go so far as to say that the apparently contradictory statements on inflation are odd. However, divergent opinion (we know of one dissenting vote--we do not know the overall tone of the discussion) is not what could destroy their credibility. Of much greater long term consequence for their credibility is whether they follow through on what they say they will do--namely to address changes in the balance of risks according to new information.

As I wrote recently,

Everyone needs to remember that transparency in the process does not imply certainty over the outcome.

Or, in a similar vein, ambiguity does not automatically mean less credibility. So, taking Tim's comments as a jumping-off point, it's time for a discussion of how much transparency we want from the Fed and how much ambiguity we can tolerate.

Let's cut to the chase. The ultimate in transparency (short of televising the meeting, which is most assuredly not going to happen) would be for the FOMC to release the "Greenbook" along with the press release. The Greenbook is the document that contains the staff forecast and is made public with the transcripts after a five year delay. Now we could debate whether it would be a good idea to make this information public. The point is that if we had that information along with the outcome of the policy decision, we would know in real time whether they are behaving in a manner consistent with a given (forward looking) policy rule.

At that point, for the sake of credibility, you might as well go all the way and institute a policy rule.

The increased transparency of the last decade has been very welcome. It has focused the spotlight on the Fed in a way that has disciplined the organization. When I look at what I teach my classes about the Fed from principles through the graduate level, I am often amazed at how much more sophisticated it is than was even possible when I was an undergraduate. We simply have more information, and we have that information instantly at our fingertips. When William Greider's Secrets of the Temple was published almost 20 years ago, the Fed was not subject to the daily scrutiny of the 24 hour financial press, the bloggers, and so forth. Public awareness and interest in the Fed is running quite high these days. Perhaps we can thank Greider for shining the light on the Fed. Certainly the mystique of Chairman Greenspan, especially after his handling of the 1987 stock market crash, had a lot to do with it. But ultimately it was the institution, led by Greenspan, that took on the challenge of making its actions known for the benefit of all. Even though they knew it might restrict them in the future. These are small steps towards a commitment mechanism.

However, the job isn't done. As the minutes of the August meeting make clear, the Fed is taking a long look at its communication policy. The experience of the last decade suggests that the more we know about what goes into the decision (this we learn from "Fedspeak") and the faster we know the decision (press releases and minutes), the less latitude they have to do things that are out of line with our expectations. Transparency enhances credibility at the cost of tying your hands. ("Measured pace," anyone?) However, tying your hands without a clear objective in mind could lead to trouble.

And so they should review their communication policy. Today's press release was a little problematic in the ways that Tim Duy points out. But even so, today's press release was more enlightening than the months worth of "measured pace" statements that, as I have said before, painted them into a rhetorical corner, unable to raise rates faster or slower than 25 basis points per meeting for fear of spooking the markets. That was not their finest hour in terms of communication skills either.

Personally I'd prefer that they release the Greenbook right away, issue a longer press release detailing some of the discussion of the Greenbook and clearly define their objective function. But that isn't likely to happen soon, so we will have to settle for some occasional abiguity to make sure that they don't get tangled up in their own rhetoric as they navigate between their dual, and sometimes conflicting, objectives.

UPDATE: New Economist is also unimpressed with today's statement.

FOMC press release

Mark Thoma does the line-by-line comparison. The 30 second summary of which is that the housing slowdown is no longer regarded as "gradual" and that energy prices are not as much of a concern as they were previously. As a result, energy prices are now mentioned in the paragraph on factors moderating inflation (because they seem to have stabilized) rather than factors moderating growth (as when they were still climbing).

On a related note, oil was down again today.

And despite the fact that Jeffrey Lacker dissented again, preferring a 25 basis point increase, there is a growing chorus of those anticipating a rate decrease in the next few months.

PIMCO has heard both sides and takes the middle road. (Reuters)

CHICAGO (Reuters) - The Federal Reserve could keep benchmark interest rates steady for some time given its focus on pulling down inflation, said Paul McCulley, managing director of the bond fund PIMCO.

"The hurdle to starting an easing process is high, because the Fed actually does want to see softer employment growth," McCulley said in a research note released on Wednesday.

"A deceleration in growth is not necessarily sufficient on its own for the Fed to start easing, particularly when the Fed wants inflation to actually come down rather than just stop going up," he said.

For the easing cycle to start, McCulley said the risks of an economy-wide recession must be more apparent. "Those risks aren't there at the moment, and on our base case forecast, they won't get there over the cyclical horizon," he said.

I know some people who would disagree strongly. However, McCulley makes two statements that seem to be on-target. While a single cut at the top of the cycle would not be totally uncalled for, it isn't likely that the Fed will start a pattern of cutting unless the economy visibly takes a turn. (Whether employment is the key variable is another matter on which I'm not so sure--employment tends to lag... they will be looking for weakness on a variety of fronts.) And second, the Fed does want inflation to come down rather than stay where it is.

But my usual advice applies. Don't pay too much attention to interest rate forecasts going out more than a few months, and even then I'd play it cautiously. We are still way too data dependent. Steady as she goes for a few more weeks, watching the housing market as well as the inflation numbers, trying to steer a course between them--hoping that no exogenous winds of change blow them off course.

Postscript: Brad DeLong writes:

Good luck, Ben and company...

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.

Via Reuters:

BOSTON (Reuters) - The U.S. economy is growing robustly despite a slowing housing sector, although inflation remains above the central bank's comfort level, two top Federal Reserve officials said on Monday.

Making separate appearances at a business economics conference, Cathy Minehan and William Poole, heads of the Boston and St. Louis regional Fed banks respectively, sounded relatively optimistic about the economic outlook.

But while Minehan focused more extensively on the softness emerging from a decline in home purchases, Poole appeared a bit more worried about the possibility that inflation could gallop outside the central bank's grasp.

Stressing the importance of maintaining Fed credibility, Poole said inflation was running above the range he would prefer to see, and said that if it did not ease over the next 18 months that he would rather "act earlier rather than later."

Minehan's speech

Poole's speech

San Francisco Fed President Janet Yellen remains confident that inflation is under control, but rising unit labor costs give her pause.

This brings me to the outlook for inflation. As I've indicated, core consumer inflation has been a bit above my comfort zone recently. Therefore, in keeping with the Committee's responsibilities for promoting price stability for the nation, I believe it is critical that inflation trend in a downward direction over the medium term. Indeed, my expectation is that this is the most likely outcome.

That said, I must admit that I'm also less sanguine than I was a month ago about one particular factor in the inflation process—namely, labor compensation. This factor is a major component of business costs and can therefore affect the prices that firms charge for their products. A month ago it appeared that compensation was growing quite modestly. Moreover, for nonfarm businesses, markups of product prices over costs have been near historic highs, which means that businesses have had room to absorb higher costs rather than passing them on to their customers. These two developments together gave me considerable comfort in thinking about the inflation outlook. However, recently revised information on compensation per hour suggests that wages and benefits are growing rapidly. This blurs the picture considerably, since another measure, the Employment Cost Index, shows only moderate growth....

...

This leads me to the concluding topic in my presentation today—monetary policy. As you know, in August the FOMC decided not to raise the funds rate for the first time in more than two years. I think this was the prudent course of action that properly balances the dual mandate given to the Fed by Congress—to foster price stability and maximum sustainable employment.

Given that inflation is outside of my comfort zone, why do I think it makes sense to pause? In these circumstances, it might be thought that policy should continue to tighten until the inflation data move back to a rate consistent with price stability. But I would argue that a gradual approach is likely to be better because there is a need to incorporate lags between policy actions and effects on the economy. We don't know what the lags are with precision, but we still need to do the best we can to take them into account. We simply don't get the necessary feedback on the effects of our policy actions for a long time. So if we kept automatically raising rates until we saw inflation start to respond, we most likely would have gone too far, which would unnecessarily endanger the economic expansion. Instead we need to be forward-looking.

And, by a variety of measures, it appears that the current stance of policy will move inflation gradually back to the comfort zone while giving due consideration to the risks to economic activity. By a variety measures, I'm referring to my forecast that I have outlined today, as well as the recommendations from commonly used monetary policy rules that are used to gauge the stance of policy. Taken as a whole, these rules indicate that the funds rate is currently within the range that appears appropriate, given the current condition of the labor market and the position of inflation relative to my comfort zone.

However, since all such approaches are inherently imprecise, policy must be responsive to the data as it emerges. The advantage of pausing is that it allows us more time to observe the data. When I say that policy should be responsive to the data, I mean that any additional firming should depend on how emerging developments affect the economic outlook. And when I say data, I don't just mean data on inflation, output, and employment. I also mean data on factors that might affect those variables in the future—such as energy prices, the dollar, the stock market, long-term interest rates, housing prices and inflation expectations.

The bottom line is this. With inflation too high, policy must have a bias toward further firming. However, our past actions have already put a lot of firming in the pipeline. With the lags in policy we haven't yet seen the full effect of our past actions. These will unfold gradually over time. By pausing, we allowed ourselves more time to observe the data and more time to gauge how much, if any, additional firming is needed to pursue our dual mandate.

Reporting on Yellen's speech, Greg Ip of the Wall Street Journal also informs us that two regional Fed banks (Richmond and Philadelphia) requested discount rate increases in the days leading up to the last FOMC meeting.

You can read the minutes from the Board of Governors here. (Remember, the Board decides the discount rate and the FOMC votes on the fed funds target.) Quoting from the minutes:

Directors who preferred to maintain the existing primary credit rate at this time pointed to slower economic growth, the lagged effects of monetary policy actions, and the stability of longer-term inflation expectations. Nevertheless, inflation pressures remained a concern for most directors, and they generally agreed that incoming data would be crucial in determining the appropriate stance of monetary policy going forward.

Directors in favor of increasing the primary credit rate noted that, while growth had slowed, it remained solid. In this light, they appeared to view the risk that inflation pressures would persist as outweighing the risk of a sharp deceleration in economic activity.

At today's meeting, no sentiment was expressed for changing the primary credit rate before tomorrow's meeting of the Federal Open Market Committee, and the existing rate was maintained.

After the FOMC meeting the next day, the Board decided to maintain the existing rate. Today's minutes answer questions that were raised back at Mark Thoma's place last month.

You can decide how much significance to place on the fact that two of twelve regional Feds wanted to continue increasing rates. I'm with Greg Ip in thinking that the support for the pause was "relatively broad." Remember also that it is the boards of directors of the regional Feds that make these recommendations. Their members are drawn from the business and banking community and have a pretty good handle on conditions in their region.

UPDATE: Calculated Risk covers the housing angle.

UPDATE 2: Bloomberg (channeled via the NY TImes) plays up the additional dissent:

WASHINGTON, Sept. 7 (Bloomberg News) — Two regional Federal Reserve banks favored an increase in the discount rate before the policy meeting on Aug. 8, a sign of greater dissent over current monetary policy than had previously been disclosed.

One (of five) voting regional banks dissented. One (of seven) non-voting banks wanted to raise the discount rate. I think that is fairly consistent with the broader opinion. I hesitate to make too much out of it, but you are free to make up your own mind.

Maybe I was just looking for it this time around, but it seemed that the Beige Book is reporting more varied economic performance across regions. Maybe it was the first paragraph that set the tone:

Reports from the twelve Federal Reserve Districts indicate that economic activity continued to expand since the last report, but five Districts indicated deceleration while the remaining seven reported little change in the pace of growth. Some slowing in economic growth was seen in the Boston, New York, Philadelphia, Kansas City, and Dallas Districts, though Dallas still characterized growth as strong. Most other Districts reported continued modest growth, though Atlanta described activity as "mixed", Richmond observed that growth was "slow," while San Francisco noted a "solid" growth pace.

On labor markets, they had this to say...

Labor markets around the nation have generally been steady since the last report. Scattered labor shortages continued to be reported in a number of Districts, though these do not appear to have intensified, except in the Dallas District. Job growth was described as brisk in the Kansas City District, and recent acceleration was noted in the Richmond District. Labor markets were characterized as steady or expanding moderately in the other ten Districts. The Kansas City and Dallas Districts reported fairly widespread labor shortages while more specific shortages were cited in a number of other Districts: Cleveland indicated a shortage of truck drivers, Atlanta noted ongoing shortages of construction and hospitality workers along the Gulf Coast (where Hurricane Katrina struck a year ago); Chicago reported shortages of skilled manufacturing workers and engineers; and Minneapolis mentioned some shortages in Michigan's northern peninsula.

Wage pressures were reported in a number of Districts, though they were most often limited to certain sectors and most pronounced for workers with specialized skills. Overall increases in wage pressures were mentioned in the Philadelphia, Chicago, Minneapolis, Kansas City, and Dallas Districts. A number of other Districts reported sharp wage increases or wage pressures for such workers in occupations that are in short supply or for workers in particular industries, such as information technology (Boston), trucking (Cleveland), retail trade (Chicago), and financial and health services (San Francisco).

All of which is good if you think that job growth is proceeding at an appropriate stable rate. Last month's payroll numbers border on the low side of what most of us would think should be consistent with a report like this, suggesting that there is more going on here than initially meets the eye. Of course, if you're an inflation hawk, the above paragraphs might keep you awake at night. By the way, in case you hadn't heard yet, unit labor costs were revised upward to 4.9% (link to WSJ article). This one-two punch gave the market a bit of a black eye, though it is certainly not down for the count.

So what did the Beige Book say about prices?

Reports of sustained increases in the cost of metals, energy and petroleum-based products, and other raw materials continued to be widespread, although increases in energy costs were reported as moderating in the San Francisco District. Some Districts reported flat to declining prices for natural gas and a moderation in the price of steel. Manufacturers found little ability to pass through higher costs into the prices of manufactured goods, with the exception of energy-intensive goods and services as reported by the San Francisco District. Many Districts reported lower prices for apparel and electronic goods, and most Districts reported that retail prices remained steady.

As James Hamilton recently reported, commodity prices are starting to come down a bit. He attributes this to the realization that the incipient economic slowdown is more significant than first thought. Oil prices fell for a third straight day, and while Chevron's new discovery will not come on line for a few years, the market appears to be buoyed enough by the news that it has an excuse to reduce some of the long term price premiums that have been keeping oil at such elevated levels.

Perhaps the next round of Fed speeches will shed some light on what weight they give to unit labor costs. I hope they do (shed some light, that is) because that looks like the one thing that could prompt them back into the mode of raising rates at the moment. Today's news may increase the probability that another rate hike is coming at the next meeting, but I think only slightly. This does, however, reinforce my opinion that more rate hikes are coming eventually.

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.

(Full text of the minutes)

The minutes of the August FOMC meeting are out. While they tell a story that we already know a great deal about, they do fill in a couple of gaps in what we know about what the Fed is thinking.

Some selected paragraphs that convey the message...

The staff forecast prepared for this meeting indicated that real GDP growth would slow in the second half of 2006 and 2007, and to a lower rate than had been anticipated in the prior forecast. The marking down of the outlook was largely attributable to the annual revision of the national income and product accounts, which involved downward revisions to actual GDP growth in prior years and prompted reductions in the staff’s estimate of potential output. The slowdown in the housing market, the effects of higher energy prices on household purchasing power, the waning impetus of household wealth effects on consumer spending, and the effects of past policy tightening were expected to hold economic growth below potential over the next six quarters. Core consumer price inflation was projected to drop back somewhat later this year and next, mainly as the effects of higher energy and import prices abated.

The fact that their forecast has been revised downward recently is significant. It was a close call anyway, and a downward revision could easily tip the scales for a lot of people. Further down the minutes...

Some participants noted that global demand remained strong, potentially adding to worldwide pressures on resources. Increased geopolitical risks, particularly related to developments in the Middle East, continued to put pressure on energy prices, and the prices of many other commodities also had firmed over the intermeeting period. Central banks had been raising interest rates globally, however, and this was viewed as a factor that should help to restrain global inflation pressures. But it was also noted that the recent decline in the foreign exchange value of the dollar could lead to a weakening of import competition in the form of increases in the prices of tradable goods in the United States.

See also: Dance of the bankers. One cannot ignore the fact that other central banks are raising rates. Global markets are integrated well enough that it could lead to exactly what they suggest in the last sentence. And that would mean... you guessed it.

As at the June meeting, all participants expressed concern about continued elevated readings on core inflation and inflation risks going forward. Several participants took note of the revisions to historical data that painted a more worrisome picture of cost trends; measures of unit labor costs had been marked up, reflecting upward revisions to labor compensation and downward revisions to labor productivity. Core PCE inflation now appeared to have been running at or above a 2 percent annual rate for more than two years, with prices accelerating over the first half of 2006. Many participants noted that the extent to which the increase in core inflation so far this year reflected transitory or persistent influences remained unclear. The recent pickup in price increases appeared to be broad-based, and a number of business contacts reported greater ability to pass through higher costs. However, some types of price pressures were not likely to continue to increase. The recent acceleration in shelter costs, which contributed substantially to the increase in core inflation this year, could prove short-lived. Moreover, while energy prices had risen further in the intermeeting period, energy prices could well level out in coming quarters. Also, the anticipated moderation in aggregate demand implied that pressures on resource utilization likely would not increase and could abate to a degree going forward. Finally, inflation expectations appeared to have remained contained despite adverse news about prices. In light of these factors, most participants expressed the view that core inflation was likely to decline gradually over the next several quarters, although appreciable upside risks remained.

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. In view of the elevated readings on costs and prices, many members thought that the decision to keep policy unchanged at this meeting was a close call and noted that additional firming could well be needed. But with economic growth having moderated some, most members anticipated that inflation pressures quite possibly would ease gradually over coming quarters and the current stance of policy could well prove to be consistent with satisfactory economic performance. Under these circumstances, keeping policy unchanged at this meeting would allow the Committee to accumulate more information before judging whether additional firming would be necessary to foster the attainment of price stability over time. The full effect of previous increases in interest rates on activity and prices probably had not yet been felt, and a pause was viewed as appropriate to limit the risks of tightening too much. Following seventeen consecutive policy firming actions, members generally saw limited risk in deferring further policy tightening that might prove necessary, as long as inflation expectations remained contained.

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.

Though rather lengthy, I quote it all because each sentence has significance. Overall, I get the picture that despite the fact that inflation has been running high, and energy prices have not abated yet, the slowing of economic growth should be enough to take the pressure off. If they are correct that energy prices will level off and core inflation at least does not accelerate further, they will have timed everything about right. They recognize the policy lags that have been in alternating between the front and the back of my mind for the last year. To put it succintly, they are betting that they are not behind the curve and hoping that they are a little ahead of the curve if there is to be a coming disinflation (albeit a slight disinflation). But it seems to hinge a lot on the revised forecast and the impression that growth is slowing. Yet when talking about inflation, they use words like:

The recent acceleration in shelter costs, ... could prove short-lived.

...energy prices could well level out...

...could abate to a degree...

Finally, inflation expectations appeared to have remained contained despite adverse news about prices.

The last is really quite a statement about the confidence in the Fed's ability to fight inflation should things get even worse. No small feat. But note that when it comes to inflation, there is heavy use of words like "could" and "appeared" and the like. That is telling. Inflation is, right now, the real wild card in the game. We do not know what is going to happen next. It "could" turn out ok, but the risks are palpable. Slowing growth, on the other hand, is becoming more and more of a fact. Whatever our deep-down feelings are about Phillips curves might be, most of us do accept that, ceteris paribus, slowing growth on the demand side does temporarily take some pressure off of inflation.

But as they say, ceteris is not always paribus.

And further down we see a short explanation of Mr. Lacker's dissent.

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. The inflation outlook had deteriorated in the intermeeting period; the recent surge in core inflation had persisted and appeared to be broad-based, while the revision of the national income and product accounts indicated a recent upswing in compensation and unit labor costs. Although real growth was likely to be somewhat lower in coming quarters, in his view it was unlikely to moderate by enough to bring core inflation down. He noted, moreover, that real short-term interest rates had fallen in the intermeeting period and were still low relative to rates typically associated with sustained expansions.

Similar concerns were expressed by Martin Feldstein. I have noted my own concern over real interest rates here and here. This seems to be Mr. Lacker's concern as well. If you get behind the curve, nominal interest rates need to go even higher than they otherwise would because you need to get the real rates (pushed down by surging inflation) up. As just about all of us have said at one time or another, this is a really tough call. The entire episode reinforces the fact that the Fed is concerned enough about the slowdown (in all likelihood influenced by their revised forecast) that they are willing to take what any central banker knows is a risk. Not being privvy to the forecast and everything else that was said in the room, I'm prepared to give them the benefit of the doubt to a certain extent. But it is clear from the minutes that the market should not interpret this as the end of the hikes. Let's hope it doesn't put them behind the curve.

Finally...

The Committee then turned to a discussion of the goals and principles that should guide the review of its approaches to policy communications that it had recently undertaken. Participants agreed that communication was important for democratic accountability and could promote the effectiveness of policy. Although considerable strides had been made in FOMC communications over the past ten years or so, participants generally thought that further advances were possible. In that regard, consideration of how the Committee expressed both its economic objectives and its assessments of expected progress toward those objectives was likely to be particularly important. Conveying the degree of uncertainty and conditionality about Committee expectations of future developments was seen as a major challenge. It was recognized that communications should support appropriate decisionmaking, including respect for the diversity of views that contributed to good decisions. Participants agreed to continue the Committee’s review of communications issues at the FOMC meeting in October.

That is a nice note on which to end the minutes. I look forward to the transcript of this in five years. I'm sure they realize that calling it a "major challenge" is quite an understatement. While "impossible" might be too strong, they do have their work cut out for them. I am hopeful that they will learn from the "measured pace" episode and be more aware that certain catch phrases can take on a life of their own. Everyone needs to remember that transparency in the process does not imply certainty over the outcome.

UPDATE: CNNMoney reports:

Economists are mixed since it all depends on which portion of the minutes you find most important. You can clearly make a case for why the Fed will hold pat in September or why the central bank will once again raise rates.

"Clearly" might be a stretch. My read of the situation at present is that the default position for the next meeting is to keep rates unchanged and that it will take some unexpected spike in inflation data to move them off that position. While I share Lacker's concern that inflation and inflation expectations could become entrenched if they are not careful, I would not necessarily predict that the next data point in particular will cause them to reverse course. It depends on whether you are thinking 3 weeks or 3 months ahead. So for now I would look for no change at the next meeting unless something pretty drastic happens in the inflation data. But looking out over the next few months, more rate hikes could be on the way if inflation doesn't abate as it "could".

And does it succeed? Better then other (private, market-based) alternatives?

This post certainly cannot answer such momentous questions. I would, however, like to use these questions as a focal point for thinking about one of the hot topics on the economics blogs. I think a lesson that comes out of this (are you listening, grad students?) is that monetary policy questions can have very deep roots in fundamental questions about the nature of money and markets. Recently, Greg Mankiw posted a letter from Milton Friedman on his blog. The final thrust of the letter was as follows. Quoting Friedman:

Nothing that I have observed in recent decades has led me to change my mind about the desirability of a monetary rule which simply increased the quantity of money at a fixed rate month after month, year after year. That rule would get rid of the mistakes and that is probably about all you could expect to get from a monetary system.

Even better would be to abolish the Fed and mandate the Treasury to keep highpowered money at a constant numerical level.

A wonderful round of comments ensued. Among them was Divison of Labour's Lawrence White. White actually wrote two posts. Quoting from the earlier of the two,

Do we need to keep the Fed around because the money multiplier might collapse again? Mankiw is right that the money multiplier declined sharply in the 1930s, but why did it? The proximate cause of the collapse in the 1930s was bank runs and fear of more bank runs. The underlying reason for the bank runs was geographic and note-issue restrictions that make US banks unnecessarily fragile. There were no bank runs and no money-multiplier collapse in Canada in the 1930s, which had neither restriction. Fortunately we no longer have the geographic restrictions in the US. We still have note-issue restrictions. Friedman’s brief letter neglected to mention an important adjunct to his base-freeze proposal that he has elsewhere mentioned, which is that shifts in the public’s demand to hold currency could be accommodated by letting commercial banks freely issue currency redeemable for base money. With well-diversified note-issuing banks, a collapse of the money multiplier would not occur.

Over at Marginal Revolution, Tyler Cowen enters the fray.

Greg counters that the lender of last resort function of the central bank may interfere with a fixed monetary rule. Fair enough (in fact I think the earlier Milton admitted this point, although the later Milton may agree with Larry White's comment on Greg), but my objection is more day-to-day. Hardly anyone is willing to live with the consequences of a strict rule for the monetary base.

In particular, the resulting short-term interest rate volatility would be much higher than, prior to experience, most people had expected. Liquidity is quite scarce. The demand for funds goes up and sometimes, in the absence of Fed smoothing, the supply just isn't there. Price has to adjust. No, interest rate volatility is not the end of the world but few people believe this makes for a better marketplace. That is why hardly anyone in the world of central banking defends monetary base targeting these days, even though the idea was fairly popular twenty-five or thirty years ago.

In a modestly growing economy, holding the money supply absolutely constant will approximate a "Friedman Rule". Students of macroeconomics will recognize the Friedman Rule as the well-known result that in a certain type of cash-in-advance model the optimal policy is to have deflation equal to the rate of time preference. This also results in a zero nominal interest rate.

In practice, with output varying around a long run trend, fixing the money supply would anchor the long-term interest rate only. Short term rates would vary depending on the shocks to output (and, importantly, changes in expectations of future output). For example, if output is expected to increase at a faster rate, borrowing will increase and the short-term rate will rise.

One of the successes of modern central banking is certainly the ability to smooth the short-term interest rate fluctuations. The directives of the FOMC, such as the most recent one that provoked so much debate, are instructions to carry out open market operations aimed at keeping the short-term interest rate at a certain level for the next six weeks. This aspect of the task is mechanical and is familiar to students in principles of macro. Without the Fed performing this function, long-term rates may be well achored, but short-term rate will fluctuate per Cowen's analysis.

Indeed one of the thorny puzzles for the Fed of late has concerned the short vs. long term rates. It was Greenspan's "conundrum"--how the long term rate could stay so low even as the short rate was rising so steadily and consistently. But this is a non-issue under a Friedman Rule. Even if we do not go quite that far, a credible commitment to low inflation should bring about increased stability at the long end of the yield curve. But to maintain that credibility in the long run, you might have to sacrifice a little bit of control at the short end. That is, you might have to let the short rate rise (or fall) in response to changes in expectations. The policymaker cannot have it both ways. You can't target both the money supply and (short-term) interest rates.

But what if, as White suggests, we allowed banks to issue private notes and traded those notes in financial markets. Suppose output is temporarily high. With a fixed supply of government supplied money, the price level would tend to fall as money becomes more precious. There is a need for more liquidity. As holders of highpowered money, banks could create the liquidity by issuing notes that would circulate until the need for liquidity subsides. These notes could be presented to settle debts between banks and between firms. If such notes were traded on an exchange, it would be immediately apparent whether there were too few or too many in circulation and adjustments could be made quickly.

Such an arrangement sounds like a 21st century version of 19th century free banking (the latter, not coincidentally being an area of interest for White). The thought of an institution or an exchange for clearing the notes reminds me (at least in a very general sort of way) of the Suffolk Banking System. I refer interested readers to a number of papers on the subject by Arthur Rolnick and Warren Weber (papers can be found at their websites). Along with the late Bruce Smith, they wrote a particularly concise and informative introduction to the subject in the Minneapolis Fed Quarterly Review. They conclude that the Suffolk Banking System, a clearinghouse for bank notes that existed in the early 19th century, was a natural monopoly. One piece of evidence in favor of this was that Suffolk's rival that eventually drove them out of business, the Bank of Mutual Redemption (BMR), may have engaged in predatory pricing. Clearninghouses such as Suffolk and BMR required participating banks to keep deposits with them (much like the Fed accomplishes clearing of payments by transferring reserves that banks have deposited with the Fed). BMR offered interest on their deposits when they entered the market, but after Suffolk exited, BMR stopped paying interest.

Stories like this are informative because they help illuminate some of the functions of the payment system that we often take for granted. So why do we have a central bank? Is it because clearing payments is a natural monopoly? But one can legitimately ask whether modern financial market technology could accomplish this function. Would this market function freely enough that short term interest rate fluctuations would be optimally smoothed? And if this market functioned well, would we need a lender of last resort?

These are very penetrating questions that cut to the heart of a monetary system. They are fundamental questions that walk the fine line between money and credit. The fact that there is still a demand for an asset bearing a zero nominal interest rate suggests that there is a market friction. Do central banks alleviate that friction or make it worse. My assessment is that they do both from time to time. But a completely private market solution would surely be a bit messy until all the problems were worked out. If we tried another Suffolk Bank today, it might work better, but there is no guarantee that it would work perfectly. Not to mention the fact that I would be slow to give up the Fed's role as lender of last resort (recognizing that this has potential problems for a fixed money supply rule).

But at the same time, if the Fed became truly serious about price stability as its only long-term goal (yes, I'm aware that would require an act of Congress), we should expect financial markets and institutions to take on some of the responsibility for maintaining a smooth functioning system--provided that the law allowed them to do so. After all, one of the functions of currency is to overcome frictions caused by the lack of information. In this, the age of information, we may have our best chance yet of seeing private markets for near money instruments assume at least some of the role for financial market stability that the Fed assumes today. However our experience with the Great Depression makes us cautious of ceding that responsibility--a fact which is at the same time understandable and unfortunate.

From the Wall St. Journal:

"The key is that they believe inflation expectations have stopped rising," Peter Frank, currency strategist at ABN Amro said. "They have not been more dovish than was expected, and that's why the dollar has not collapsed."

The as-expected statement from the Fed is therefore unlikely to change the market's general dollar-bearish tone, analysts said.

Ouch.

Today, the FOMC decided to leave rates unchanged for the first time since June 2004. We knew it was coming eventually. Beginning last summer many of us started to wonder if a temporary end to the rate hikes would come by year's end. By year's end, it looked like it would be this summer. Even up until a few weeks ago, one last rate increase today would have been seen as likely. That sentiment eroded and practically disappeared last Friday. Speeches by Fed officials, including Mr. Bernanke's congressional testimony cracked the door and the non-farm payroll data threw it wide open. And while the statement was not as hawkish as some might have hoped, the late afternoon interpretation seems to be that the market believes more rate hikes are possible. It is also possible that the thought of a slowing economy is starting to sink in on Wall Street as well.

Around the web, Mark Thoma compares the language of the last two statements. Several things do stand out. First, they report that economic growth has moderated as opposed to "is moderating". They removed the statement about productivity gains, likely this was in light of this morning's news revising productivity downward for the last couple years and lackluster gains in the 2nd quarter. They also removed the sentence, "In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives." I would like to know about the discussion that led to the removal of that sentence. Personally, I don't think that sentence provided any particularly useful information. If there is doubt on that issue, the rest of it doesn't matter. Perhaps they were trying to cut down the excess verbiage.

Barry Ritholtz does not approve of the decision or the statement.

From the NY TImes,

The Fed appears less concerned about a recession. In its statement today, it described economic growth as moderating, not stalling or slumping.

And that does add credibility to the notion that more rate hikes are possible. If they were really worried that a recession was immenent, this would be the end, not just a pause.

Greg Ip does his usual fine work in the Wall St. Journal. Read the whole thing.

Also from the Wall St. Journal On-line, in their "Economists React" page, there are a number of good entries. This one caught my eye,

Richmond Fed President Lacker dissented in favor of an increase, so the vote was 9-1. That should not, however, be taken as a signal that the discussion was not contentious… I would imagine that there may have been other who could have gone either way and perhaps even some non-voters who would have dissented if they had a vote. So, now the Fed, economists, and market participants will sit back and watch the incoming data to figure out whether the economy continues to cool and whether there is any sign of a moderation in core inflation. RBSGC believes that activity may pick up a bit and that core inflation will remain too fast, so we look for one more rate hike on Sept. 20. -- Stephen Stanley, RBS Greenwich Capital

It is indeed possible that this was very contentious. The dissent of one member speaks volumes. Generally only one member dissents, even if there is deep division. This may be one of those times. It is also interesting to see some of the television commentary on the decision. Former San Francisco Fed President Robert Parry was on Bloomberg shortly after the decision and while he was not overly critical, he did not think that the present policy stance was too restrictive.

This decision is going to be critiqued for some time to come. There are plenty of commentators out there who wanted one more hike. Of course, I would be remiss if I didn't point out that there are plenty who think the Fed has already gone too far. My opinion remains that the real interest rate is low enough (barely cracking 1%) that it is not terribly restrictive and has room to move upward. Also, the Taylor rule indicates that current policy is still accomodative. There is a good possibility that rates will indeed be pushed higher down the road, and I'd rather see it sooner than later. While I would stop short of calling this a mistake, I think it is risky. I'm more worried about the inflation risk than the recession risk at the moment, and I don't think that monetary easing is going to suddenly reverse the labor market weakness that has lasted throughout this recovery. Nor do I think that another 25 basis points would capsize the labor market.

But for now, the decision is made. The Fed is taking the chance that moderating growth and the lagged effect of past rate increases will keep inflation at bay. They have confidence in their forecasts. If core PCE inflation holds steady in the next couple months, this could be the breathing room that they have been seeking. But the big question on many people's minds is what if core PCE inflation continues to tick upward? How long will the Fed wait to address the issue? Would they act in September or hold out until October? Until the next round of speeches by FOMC members, it will be hard to say. I will be particularly interested in the release of the minutes of this meeting to see what kind of concerns were expressed regarding inflation and the level of restrictiveness that members perceived in the current policy stance.

Just for kicks, I looked at what I wrote on June 29.

I can envision scenarios in which there is a pause in August, and that is something that I could not say about the June meeting.

And so it goes. If anyone asks me right now what I think about September, my response would be, "What part of data dependent don't you understand!" We really are in a mode of waiting to see if the Fed's forecast of moderating inflation turns out to be true. Depending on that data, the next two meetings could go either way.

The stock market likes low interest rates because they stimulate investment and because a lower interest rate means less discounting of future profits. Of course, a slowing economy is not good for investment or profits. Hence, all the jubilation over the possibility of a pause in the rate hikes might be a little premature. (CNN Money)

Yippee! Stocks rallied; bonds surged; bets for a rate hike Tuesday dwindled down to 16 percent from 41 percent the previous day, according to Chicago futures trading.

And within an hour the rally was gone.

"The market seemed to realize almost immediately that the Fed pausing now because it is worried about economic growth is not a good thing for stocks," said Ken Tower, chief market strategist at CyberTrader. "Weaker economic growth means weaker profits."

...

[MKM Chief Economist Michael] Darda said that he thinks the economy will show greater strength in the fall, which could lead to a need for more rate hikes. Additionally, all the analysts said that they were worried that rising inflation would force more rate hikes going forward, a scenario even more troubling for stocks.

Not sure about Darda's comment. I'd expect somewhere in the 2.5% to 3% range for GDP growth, which is not necessarily enough to trigger more increases. It is, of course, the inflation part that worries me. If they let real rates fall and expected inflation rise as a result of pausing too soon, then you could have a much more difficult situation to deal with.

So... bottom line: what will they do? The IEM is putting it at about 70-30 for a pause. That's up from 60-40 on Friday. It will probably inch higher by tomorrow. At this point I'd regard a pause as at least that likely. I still think there is a possibility of an increase but the more the market's expectations get entrenched, the further the Fed would have to go out on a limb to go against them. So it's not a sure thing, but it's tough to bring yourself to bet against it. I would prefer one more increase, but you knew that already.

Will there be dissent? Who knows. That's not something I'm going to try to predict. Remember that in Fed culture dissenting sends a strong message. Generally no more than one person dissents even if there is significant opposition. Early in the term of a new chair, I would expect that members would want to maintain a unified front. The bar for dissenting might subjectively be set a little higher, even for hawkish members. If the vote is unanimous, I would not interpret that as meaning that there is no sentiment that rates need to go higher. We will need to see the minutes in 3 weeks to know more. I know that some of my more hawkish readers may want or expect someone to dissent. There may be, but I'm just saying not to expect it or read too much into the lack of it. A unanimous decision now does not preclude rate hikes in September or October, if necessary.

UPDATE: Barry Ritholtz puts a higher probability on an increase than I do.

I think the odds of a 1/4 point hike is much higher than people think; I place it at 49%, versus the 18% or so the Fed Fund Futures have on it

I'd split the difference at around 30%, maybe a little less.

Meanwhile, King Banaian returns to SCSU Scholars and would bet on an increase.

I know what the numbers say. I also think I have a handle on Bernanke; he is sufficiently stung by previous perceptions of being an inflation dove that he probably needs one good 'sting' of the markets to get them to pay attention to what he says rather than what they think he's going to do. I won't be surprised if the string of increases ends tomorrow, but I'm betting on the momentum instead.

...

This is a cautious bet, so I'm only putting down $10 -- i.e., half the beer money -- on a rise tomorrow. But still, at about 4-1 odds it's a nice opportunity. Besides which, if the Fed starts saying the economy has slowed... If I'm right, want to bet on the market's reaction? I say 'up'.

Sounds like King and I are on the same page. No one is talking about betting the farm here, but I certainly think the market's 18% probability is underestimating the potential for a surprise. How will the market react? Well, given how often I talk about the stock and bond markets overreacting to Fed statements, I'm not even going to guess. The market may need some time to digest it before it figures out where it is going.

One of the nice things about blogging is that you can go back and revisit ideas from the past because the blog archives all of those old words and pictures as if you wrote them yesterday. For a professor, this is nice because invariably you want to bring up things that you discussed in the past, but a new set of students needs to get up to speed. In economics, it is essential to have access to that background. This post is in that spirit--just in time for classes to start in a couple weeks. Just about exactly one year ago I wrote this post that looked at the core CPI inflation rate and payroll employment starting from the trough of the last two recessions. Go back and take a look.

Here are the corresponding charts updated to the lastest data (including the labor market data from Friday).

The payroll charts tell us what we already know, but put it into context with the previous recovery. With the exception of the last few months, job growth has hovered around the 150,000 per month widely recognized as necessary to keep up with the growth of the population. There has not been the kind of robust recovery of jobs that came along after the 1990-91 recession.

Note also that the point in the recovery from the 1990-91 recession that corresponds best to today is early 1995. The labor market did experience a bit of a slowdown in 1995, and the possibility of recession was openly discussed. At the same time, inflation, which had been high at the start of the recovery, was starting to come down. This was the beginning of one of the most successful non-recessionary disinflations that this country has seen in the modern era. And in Feburary 1995, the Fed raised rates one last time by 50 basis points to 6.0% where it would stay until July when rates began to fall slowly for the next couple years.

Remember, the 1994-95 episode was a success in terms of a soft landing--a cooling of GDP to a sustainable pace, fall in inflation, and no recession.

Is it any easier to predict what is coming on the basis of this information than it was last year? Not really. I do have to say one thing, however. The totality of the picture is less encouraging than it was a year ago. Martin Feldstein shows his concern in Monday's Wall St. Journal opinion pages.

The Fed governors and Reserve Bank presidents appear to believe this [soft landing] will happen. Their "central tendency" economic projections, summarized in the July Monetary Policy Report, state that the Fed's favored measure of inflation, the PCE price index excluding food and energy, will decline from the 2.9% rate in the most recent quarter to between 2% and 2.25% in 2007, presumably on its way to Ben Bernanke's "comfort zone" of 1% to 2% in 2008. They project this to occur with real GDP growing above 3% and the unemployment rate remaining under 5%. Indeed, not a single one of the 19 FOMC members projected growth of less than 2.5% in 2007 or an unemployment rate above 5.25%.

Although this optimistic outlook is possible, experience suggests that it is unlikely. A mild slowing of economic growth is generally not sufficient to reverse rising inflation. That generally requires a sustained period of excess capacity in product and labor markets, with GDP growth falling significantly or even turning negative.

The last recovery being an significant exception to that rule, but as we have discussed, that requires everything to go right, especially productivity. Feldstein continues...

The official estimates of productivity growth showed a gradual decline of productivity growth in the nonfarm business sector from 3.9% in 2003 to 3.4% in 2004 and 2.7% in 2005. The result of the slower productivity growth and rising compensation per hour (from a 4% rate in 2003 to 5.1% in 2005) caused the increase in unit labor costs to accelerate from 1.3% in 2003 to 2.1% in 2004 and 2.8% in 2005. Taking the new GDP estimates into account is likely to lower the calculated productivity growth rates and cause estimated unit labor costs to have risen faster than 3% in the most recent quarter. There is no reason to anticipate a favorable productivity surprise of the type that contained inflation in the 1990s.

...

While this risk provides a rationale for a pause at tomorrow's meeting, it would be wrong to focus just on this downside risk. The probability that inflation will rise above the FOMC forecast is at least as great. The unemployment rate of 4.8% still represents a tight labor market. Waiting for more data before deciding to raise rates is not costless. If the Fed does not act and core inflation continues to rise, expected inflation may rise further. Higher expected inflation would cause faster increases in wages and prices. If the core PCE inflation rate rises above 3% in 2007, it would take a very substantial slowdown and a large loss of GDP and employment to bring it back under 2%.

In assessing the current interest rate decision, the FOMC members should recall that during the Volcker and Greenspan years the Fed pushed the fed funds rate to 8% above the concurrent rate of CPI inflation in the early 1980s, to 4% in 1989 and to almost 3% in 2000. That measure of the real fed funds rate is now less than 1%.

The Federal Reserve has a difficult task ahead. It is understandable that it would like to achieve the soft landing of low inflation with continued solid growth. But that may not be possible. And if the Fed wants to convince the markets that inflation will be contained in the future, it must show that it is willing to take the risk of tightening too much.

Feldstein is entirely correct to point out the real fed funds rate is still a bit low. This is what I have railed about time and again. If it is not possible to have the soft landing as we did in the '90s, then this meeting is a test of inflation fighting resolve. One long term lesson this episode may provide future generations of policy makers is just how important productivity growth is for cushioning the economy in situations like this. Without productivity growth, and worse yet with further increases in oil prices, it forces the Fed to go further than it would have ideally wanted in order to get the real rate where it needs to be. I am sympathetic to the argument that they should have raised rates faster in the early going (2004) to head off the rise in inflation. But in light of the weak labor market data--a labor market that the above charts show just never got off the ground the way it did in the mid-'90s--I can't say that I would have done anything differently. To raise rates too quickly while productivity growth rates were falling might have choked off the recovery even sooner.

On that note, I conclude with this little blurb from the NY Times.

DO WE HEAR A PAUSE? The central economic news of the week will emerge from the meeting of the Federal Open Market Committee, which will decide whether to raise the benchmark short-term interest rate — now at 5.25 percent — yet another time. On the one hand, many economists predict that the Fed will leave things unchanged, which would be welcome news for investors, but then again, who knows? The dearth of one-handed economists is legendary. (Tuesday.)

Try as I might to be single-handed, I can't say for sure what the Fed will do. I can come up with a lot of reasons to raise them one more time. I do worry a bit about the 6 to 18 month picture for inflation if they pause now. I'd like the increase to be now and the pause to be for the remainder of the year. But the markets have made up their mind, and Bernanke may not want to stir them up too much. They could very well send a strongly worded statement that though they pause now an increase in October is the default option unless new data changes that stance. If such a statement comes off as credible, it would be an acceptable compromise. We shall see.

UPDATE: The September meeting escaped my mind. Change the above to read September or October.

UPDATE 2: It gets worse. Michael Mandel reports that productivity figures for 2004 and 2005 are likely to be revised downward.

UPDATE 3: Mandel was correct. Productivity was revised downward for the last couple years and the 2nd quarter of 2006 came in at 1.1 percent growth. The trend is downward. While Mandel tries to tell a positive story of the 10 year productivity growth rates, his chart shows exactly what is troubling in this situation. In the mid-'90s, the trend was reversing and going up making it easier to contain inflation. Today, the growth rate of productivity is falling.

By now you've probably heard that payroll employment only increased by 113,000. And what did I just say?

Anything between 125,000 and 150,000 would cause me to raise my subjective odds of a rate hike slightly. Anything over 150,000 would raise those odds a bit more. If it does come in at less than 125,000 I'd be willing to listen to the argument for a pause again, but I'm not sure I'd flip.

Indeed, I am willing to listen. James Hamilton just posted his latest analysis showing that a pause is coming based on futures data, which he shows is a very good predictor. Hamilton writes,

In any case, the BLS release seems to have settled the argument, as least as far as the CBOT Fed watchers are concerned.

He's not alone. Here's a quote from the NY Times:

“This evidence should seal the case for a pause in rate hikes,” Nigel Gault, an economist with Global Insight, wrote in a research report today. “Given the slowing growth picture, the Fed is likely to decide that the prudent course is to await more evidence rather than risk overdoing the tightening” when it meets on Tuesday.

From the Wall St. Journal:

U.S. payrolls posted their fourth-straight tepid gain last month and the jobless rate spiked higher, likely giving Federal Reserve officials all the evidence they need to pause their two-year tightening campaign at next week's meeting of the Federal Open Market Committee.

"All the evidence they need"? "Seal the case"? Those might be a bit strong. Let's get one thing clear. The market does expect a pause. If you're predicting it based on what the markets (futures, bonds, and stocks) are saying, you've got to say pause. But that's not the end of the story. Will the Fed surprise the markets?

While my subjective probabilities may have changed, my basic analysis has not. Recent data has shown both a slowing economy and rising inflation. Given that the Fed knows how important it is to keep inflation and inflation expectations under control, they are paying very close attention to the inflation data. Until this morning's labor report, I would have (as I expect many at the Fed would have) put more priority on the inflation problem. The GDP report was not enough for me at the time.

But viewed together, the GDP report, the labor report, and other recent evidence all seem to point in the same direction. The economy is slowing. Not crashing. Not yet on the brink of recession. Slowing. Is that a reason to put the pause sooner rather than later? Perhaps. But I have a Ritholtz-esque concern. My concern is that if the Fed pauses on Tuesday the market interprets them as being done. If inflation does keep rising in the second half of the year, the accompanying rate hikes later could wreak havoc with the markets. How can the Fed prevent such misunderstanding? They'll need a very craftily worded statement. Something like, "...the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives" is not quite strong enough, I believe. Not exactly sure how I would word it, but if the Fed pauses now they need to clearly state that they will raise rates in October if inflation continues to rise.

With a well-worded statement, I could support a pause at this meeting. I still think that when they sit around the table on Tuesday they'll have enough ammo to support either decision. I've been anticipating a pause for a long time but for the last several months have been concerned that a pause too soon could allow real interest rates to fall too much and make things difficult later. And while I have been reluctant to bring it up because the Fed is somewhat independent of the political process (but then again, they don't operate in a vacuum either), it would be nice to pause in October before the election. Then comes December and the Christmas season. There is something to be said for firing one more shot now and hoping that you can ride out the rest of the year. (Just please don't characterize that as being "one and done".)

I want to believe that inflation will be kept under control by the lagged effect of previous rate increases, but I am not 100% convinced. I guess that makes me a "hawk" in the current circumstance. Overall, this is one of the toughest races I've ever had to handicap. I'd probably say 60-40 in favor of a pause in light of the labor data, which is in line with the IEM prediction at the moment. All I can say for sure is that whatever the outcome I will not be terribly surprised. The same cannot be said for the broader markets. They've made up their mind. I wouldn't underestimate the Fed's willingness to surprise them, but I wouldn't bet the farm on it either.

Working on a data oriented post (lest the blog be overrun with policy oriented handwaving)... should have it up this weekend. Have a good one.

From the Wall St. Journal:

A price index for personal consumption expenditures -- or PCE -- that excludes food and energy increased by 0.2% in June, the third straight month it has risen that much. Compared with a year earlier, the core PCE price index grew 2.4% in June, the fastest growth since September 2002. The June rate was up from the 2.2% pace in May and April of this year.

Barclays Capital bond market strategist Michael Pond said the year-to-year increase is consistent with the Fed's forecast for the end of this year, but the "upward trajectory" seen already will concern policy makers.

And also...

Last month the Fed raised its forecast for core PCE inflation this year to 2.25%-2.5% from a previous projection of about 2%, while expecting 2%-2.25% inflation next year. The forecast suggested the Fed can tolerate inflation above its preferred 1%-2% zone for some time because it expects slowing economic growth and stabilizing energy prices to ease price pressures eventually.

Bank of America Treasury strategist George Goncalves said Tuesday's inflation data suggest the Fed will have to raise its short-term interest rate target again at its Aug. 8 meeting.

That's not the only news today. Manufacturing remains strong, and pressure on raw materials prices show signs of easing. (NY Times article).

The National Association of Purchasing Management-Chicago said yesterday that its regional index rose to 57.9 this month, from 56.5 in June. A reading greater than 50 signals growth. A separate index of prices paid for raw materials fell from its highest level in 18 years.

On days like this, I always look forward to Barry Ritholtz's take. I was not disappointed.

Once again, the portfolio wrecking crew know as "Team One & Done" have suckered investors for the umpteenth time (we have lost count) into believing that there is little inflation, the economy is slowing, and therefore the Fed is done.

Astonishing.

Indeed. If you have been following my blog for very long, you are aware that I try to avoid going back and forth on whether or not there will be a pause. My opinion has not changed much from what I wrote after the last Fed meeting.

If economic conditions remain status quo, the default option is to continue rather than pause. There is some evidence that higher energy prices are being passed through to the rest of the economy. Interest rates may have to go a little higher to make sure that this pass through is minimized.... Figuring out what the appropriate level is--in real time--is not a trivial matter.... Fortunately, ... we are not starting out quite so far behind the curve, but if we are behind the curve at all, it means that it will take more effort from the Fed to get real rates where they need to be. That is a risk that cannot be ignored.

As long as we're digging in the archives, let's go back almost a year. Last summer, recognizing that a pause was neither imminent nor necessarily advisable, I argued for a pause as early as December. By November, as inflation data came in and economic growth continued unabated, I could see that the rate hikes could continue for a while and that it wouldn't necessarily be a bad thing. In an Econoblog with Tim Duy, I wrote,

If incoming data forces us to redefine "neutral" as something higher, then (all other things being equal) I am slightly less worried than I was this summer about policy error. What concerns me more is, as you suggest, the need to communicate the transition to a new policy, especially if the economy begins to slow and the Fed is forced into some tough choices. If GDP growth slows at the same time that the recent increases in energy prices finally feed through and increase core inflation, the Fed must decide which objective is the most critical. If you advocate inflation targeting ..., your choice is clear. I sense that some of the more vocal opposition to Mr. Bernanke is coming from ardent proponents of price-level targeting who fear that he may not be tough enough.

It's been about 9 months since that Econoblog, and a year since the summer of my concern over policy error. "Neutral" has been defined upward, and the effort to communicate the Fed's new policy stance is, shall we say, "in progress." Concerns over Bernanke's inflation fighting credentials are still evident. As a result, I think there is a sentement developing that if the Fed did pause now in the face of today's inflation data it would paint Bernanke as extremely dove-ish.

I think it is a little more nuanced than that. The real issue is how you see the balance of risks to the economy shaping up in the 6 to 18 month time frame. James Hamilton does a nice job of laying out situation (prior to today's inflation numbers). It's the classic slow growth vs. inflation risk trade-off that any beginning student learns. More specifically to our current dilemma,

A. Energy prices may stay elevated, but they are not going to increase as they have in the last couple of years. Further, most of the pass through has already occurred. Thus inflationary pressures will start to ease gradually over the next year. As that happens, the real interest rate will rise, even if nominal rates are constant. This could threaten business investment in 2007. Coupled with a housing slowdown, this makes a recession likely.

B. Energy prices could go higher, and it is possible that some of the pass through has yet to occur. Rising inflation is keeping real interest rates too low to have the desired effect. Some might even say that this is the price we are paying for the "measured pace". Stopping too soon could turn what should have been a transitory inflation episode into something more serious. Inflation will remain at this elevated level until the next recession (a mini-repeat of the late '70s, though much less severe).

So which camp are you in? Today's data tells me I can't quite dismiss possibility "B" yet. If I'm advocating for a policy, I still say one more hike, then pause, then re-evaluate in December. Predicting what the Fed will do is another question. Do they lean towards "A" or "B"? Reuters tries to figure it out, but they don't see a clear answer either.

[SF Fed President Janet] Yellen said she believes the Fed needs to be "modestly restrictive" given the tightness of labor and product markets, but she concluded rates were in the "vicinity that is roughly appropriate" to keep inflation contained.

...

Some officials, however, may want to err on the side of higher rates out of concern that doing too little now may make their job that much harder should inflation risks morph into inflation.

"A slowdown is coming, but there are other factors sustaining hearty growth for now, and inflation risks are still rising," Richard Berner, chief U.S. economist at Morgan Stanley, said in a note to clients. "Consequently, it's premature to think that the Fed is finished tightening, much less that officials will soon ease."

But for every hawk on Wall Street, there seems to be at least one dove and markets see a better-than-even chance of the U.S. central bank holding its fire on August 8, although that could shift when key employment data is issued on Friday.

"Recession odds right now, according to our model, are around 40 percent, which is exactly where they were when the Fed went on hold in the summer of 2000," David Rosenberg, chief North American economist at Merrill Lynch, said in a note.

Yellen's entire speech can be read here. It is worth your time, especially the part on inflation, of which I reprint one paragraph.

Next, there is the issue of the role of energy prices in the recent disappointing data on core inflation. As I said, core inflation excludes energy prices. But there may have been some passthrough of higher energy prices into the prices of core goods that use energy as an input to production—airfares are a good example. If this is the case, and if energy prices level out as expected by futures markets, this pressure is likely to dissipate at some point. However, the whole question of passthrough is actually the subject of some debate. For example, recent evidence suggests that there has been much less passthrough in the past twenty-five years than there was back in the 1970s, when inflation got out of control in the face of soaring energy prices. If it's true that there's only a very small passthrough of higher energy prices to inflation currently, then that raises the concern that something more fundamental is pushing up inflation. Unfortunately, at this point, it's too soon to untangle these alternative interpretations.

Viewed in light of my description of scenarios "A" and "B" above, it's easy to see that this issue is far from settled and that intelligent people can differ. For my part, I think that Yellen gets it about right in describing the issue. I think there is probably more concensus about the risk of a slowdown than there is about the passthrough of energy prices and the risk that this temporary inflation episode is not so temporary. So while I lean towards advocating (and expecting--though it is a close call) one more hike, I would not cringe mightily at a pause. A pause simply means that the FOMC is tilting towards scenario "A" and that they see passthrough as becoming less of a problem as time goes on. Sooner or later, they will pause. The only question is what another quarter point would do to the expected, and ultimately the actual, path of the real interest rate over the next 6 to 18 months. That is perhaps the most critical, and most difficult question on the table.

UPDATE: Tim Duy weighs in. He wants to believe that a pause is coming next week--quite frankly, so do I--but he can't quite bring himself to believe. Nor can I. The financial markets also want to believe, and are having an easier time convincing themselves. Duy concludes,

Perhaps tomorrow’s employment report will help lift the cloud…

Well, the consensus forecast according to the WSJ is for 150,000 new jobs. I'll tell you right now that if the actual comes in close to that, it won't lift the cloud that much. Anything between 125,000 and 150,000 would cause me to raise my subjective odds of a rate hike slightly. Anything over 150,000 would raise those odds a bit more. If it does come in at less than 125,000 I'd be willing to listen to the argument for a pause again, but I'm not sure I'd flip.

Hal Varian compares the international financial system to a ballroom dance. (NY Times)

The international financial system is like a 19th-century ballroom dance. The central bankers lead with an interest rate adjustment. Their partners, the global investors, watch them closely, trying to anticipate their every move. In the background, the waiters carry their trays of imports and exports slowly back and forth, taking their cues from the pace set by the dancers in the center of the ballroom.

It's worth your time to read the whole article if you're new to the topic of global interest rates. Mostly, he summarizes what readers of the financial and macroeconomic blogs already know. He concludes...

The current interest rate increases are an attempt to slow the economy to avoid inflation. But over the next decade, we may be forced to raise interest rates simply to attract foreign lending to finance our budget deficit.

Such high rates would damp economic growth, putting more pressure on the Fed to return to the low-interest, easy-money policy we have seen in the past few years.

Such a policy runs the risk of stimulating inflation. The easy-money policies in the past few years have had a surprisingly small impact on wages, in part because of the threat of jobs moving to countries with lower labor costs. But if the dollar fell far enough, foreign labor would no longer be a bargain, giving domestic workers more leverage in wage negotiations.

In this chain of events, an inflationary spiral would become a real possibility, making the cost of a stumble on policy higher. Let us hope central bankers can keep dancing in step as they move interest rates back to normal levels.

These op-ed columns are a difficult way to educate the public on something with as many twists and turns as international finance. I enjoy Varian's writing, and wish he had more space to elaborate. But comparing central banking to ballroom dancing does get across a subtle point to the Times' readers. That point is that in a global economy, no central banker can do things entirely as he pleases without taking into account the other bankers.

UPDATE: Mark Thoma has some fun with Varian's piece.

He is an outstanding choice. He will fill the seat vacated by Roger Ferguson which expires in 2014. Governor Mark Olson recently announced his resignation which is effective today. Olson did not attend this week's meeting. Read the NY Times article on the Mishkin nomination. A Bernanke and Mishkin combination lends a lot of academic credibility to the Fed. I'm very pleased with the news.

Professor Mishkin, 55, has been a prolific author of books and articles about central banking and would add weight within the Fed to backers of "inflation targeting," a policy of basing decisions on explicit and publicly disclosed benchmarks for inflation.

On that issue, Professor Mishkin would be a close ally of Ben S. Bernanke, the new Fed chairman. Mr. Bernanke has been a champion of inflation targeting, an approach that his predecessor, Alan Greenspan, viewed as too rigid and that some Fed governors continue to oppose.

Professor Mishkin and Mr. Bernanke collaborated on a book and several articles about the issue, arguing that the strategy would make the Federal Reserve's decision-making more open and predictable.

...

Professor Mishkin is believed to be a political independent, and has had almost no involvement with Republican politics. Donald L. Kohn, whom Mr. Bush recently named as vice chairman of the Fed, is a political independent who was a senior staff official at the Fed before being named a Fed governor in 2002.

Read the press release:

Recent indicators suggest that economic growth is moderating from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.

Readings on core inflation have been elevated in recent months. Ongoing productivity gains have held down the rise in unit labor costs, and inflation expectations remain contained. However, the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures.

Although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives.

They say that "inflation expectations remain contained." That's a lot different from being "unhinged." My take on the language of this announcement is that a 50 b.p. increase in the near future is pretty unlikely, but that another one or two quarter point steps are probably in the cards. If economic conditions remain status quo, the default option is to continue rather than pause. There is some evidence that higher energy prices are being passed through to the rest of the economy. Interest rates may have to go a little higher to make sure that this pass through is minimized, even if the relative price of energy stays higher for a long time. Figuring out what the appropriate level is--in real time--is not a trivial matter. The successful "soft landing" of the mid-'90s took place when oil was closer to $20/barrel. The last time we had to fight inflation when oil prices were at these levels in real terms, things did not go quite as well. Fortunately, this time we are not starting out quite so far behind the curve, but if we are behind the curve at all, it means that it will take more effort from the Fed to get real rates where they need to be. That is a risk that cannot be ignored.

UPDATE: A lot of commentary is focused on the potential for a pause. Given that for a year or so now I've been talking about when the Fed might pause in raising rates, I figure I should comment a little more on this aspect of the decision. In the original post above, I did say that I think the default is one more increase if the data is status quo. I'll stick with that. I think that inflation is currently at the top of just about everyone's comfort zone, and it will take a fairly clear indication that the recent rate increases have been successful in turning the tide before they let their foot off the brake. How will we know? Listen for the speeches from Fed officials ("Fedspeak") after the next few data releases. I would expect them to point to clear evidence from recent data given that the official announcements have been emphasizing that we are in a "data dependent" mode. That's the bottom line.

Remember what I said about "necessary but not sufficient"? Here we have another example. This announcement does open the door, but they do not have to walk through it. I think a pause is fairly likely at one of the next two meetings. Which one will it be? I think it is too soon to say.

I would caution against reading this statement in a vacuum (as some in the stock market might have done this afternoon). The context is a long series of data on increasing inflation and concerns about inflation expectations. There are differing views on the FOMC about how far to push the rate hikes. I would imagine that the discussion at this meeting was rather spirited. (Can't wait for the minutes to be released!) I would also imagine that at the next meeting there will be some members (St. Louis's Poole, perhaps) who would advocate pushing a little past "neutral" to ensure that expectations stay contained. All of this together leads me to say that a pause is far from a sure thing in August. But the flexibility of the FOMC to do what it has to do to meet its objectives has increased a bit. I can envision scenarios in which there is a pause in August, and that is something that I could not say about the June meeting.

I've been quiet about the FOMC meeting lately since there really hasn't been anything to shake my opinion of what will happen tomorrow. I think a quarter point is pretty much a given, and "data dependent" is the new "measured pace". I expect that the announcement will retain most of the usual language with maybe a marginally thougher tone towards inflation. Barry Ritholtz has a discussion going about whether they might go with more than a quarter point. While it is entirely possible to form an academic argument as to why 50 b.p. might be needed, it is much, much harder to imagine it actually happening in the current environment with an economy that is good but not great, a nervous stock market, and comments from Fed officials that have not exactly telegraphed a 50 b.p. rise.

That said, I have already indicated my unease with the thought of the nominal funds rate merely keeping up with accelerating inflation. Then the danger is that people will start to think that this is more than just a transient spell of inflation and longer term inflation expectations would be pushed upward. A rise in inflation expectations is both a symptom of troubles that have been brewing and a problem for the Fed going forward. It would be a turning point in seeing things go from good to not-so-good. So you should understand why things like this get my attention:

CHATHAM, Massachusetts (Reuters) - U.S. inflation expectations have "come a little bit unhinged" and if they rise, cutting U.S. inflation could be difficult and costly, Federal Reserve Board Governor Donald Kohn said on Friday [June 16].

"Inflation expectations have come a little bit unhinged -- it's not a lot, it's not a big deal, but it has presented us with some issues," Kohn, the nominee to be vice chairman at the central bank, said during a panel discussion at a Boston Fed conference on global imbalances.

The phrase "a little bit unhinged" sounds like an oxymoron, sort of like being a little bit pregnant. Either you are or you're not. If you want to take a stand that inflation expectations are on their way up and that it is a "big deal", then you have to be willing to put it in the post-meeting announcement. (I'd refrain from using words like "unhinged" or "big deal" in the announcement, of course.) That would be a clear indication that 50 b.p. is on the table.

Until then, "data dependent" and "measured pace" are all the same to me.

The inflation news wasn't good, but it is probably safe to say that most of us would have been more surprised if the news came in lower than the forecasts. Right?

Barry Ritholtz says it best,

Everybody seems to be all abuzz about today's CPI number. Its no big whoop.

Why? At this point, I think we can all agree that a 1/4 point increase at the June FOMC meeting is a foregone conclusion. So that makes today's data more or less irrelevant to that meeting. Even if the inflation data comes in extremely benign, its but one point in a data series. Its doubtful it will impact the Fed's thinking about the next tightening in any meaningful way.

True. If this is an aberration (at what point do repeat performances stop being aberrations?), then you could argue to let-bygones-be-bygones and call off the dogs in August. But that is looking a little less likely with every data point.

Shifting the discussion only slightly, I note that Chris Dillow reads Mark Thoma and has this question among others...

Is there a danger that higher rates might actually validate high inflation expectations? The private sector might regard a rate rise not as a sign that the Fed is willing to reduce inflation, but rather as confirmation that inflation is indeed a big risk. If higher interest rates lead to higher inflation expectations, they lose much of their power to reduce actual inflation.

Not a pleasant thought. This is just another way of asking if the Fed is doing enough to raise real interest rates. Raising nominal rate just enough to keep up with inflation isn't going to cut it. But failing to keep up damages their credibility.

And so we come to the punch line. We have said for more than a year that the Fed has to get the funds rate to "neutral"--whatever people thing neutral happens to be at the time. Recall that this tightening campaign is about to reach its two year anniversary. Let's go back to the July 2004 issue of National Economic Trends (St. Louis Fed) to see what was being written then.

One simple rule of thumb for a neutral rate adds trend productivity growth, trend labor force growth, and a longrun target inflation rate together to yield a target federal funds rate consistent with the economy’s long-run growth potential and the FOMC’s inflation goal. Many analysts assign 1.0 percent for long-run labor force growth. In 1994, 3.0 percent might have been a reasonable assumption for an inflation target, whereas today 2.0 percent might be a better guess. Trends in productivity growth are harder to discern.

During the early 1990s, trend growth in nonfarm business sector productivity was often assumed to be about 1.5 percent. The three figures (1.0 + 3.0 + 1.5) then sum to 5.5 percent, and the 1994 tightening episode indeed ended with the federal funds rate just over that level, at 6.0 percent, in early 1995. But since 1994, trend productivity growth has increased. In fact, recent nonfarm business sector productivity growth has been shockingly robust: 4.9 percent in 2002 and 4.4 percent in 2003. Even if the underlying long-run trend is only 2.5 percent, that still suggests a sum (1.0 + 2.0 + 2.5) yielding a neutral federal funds rate of 5.5 percent, just as in 1994.

Annual productivity growth from 2004:Q3 through 2006:Q1 has been quite close to 2.5%, so one of those numbers is spot-on. But if inflation continues to drift upward it's going to take more than a funds rate of 5.5% to crank inflation back down to a target of 2%.

Bernanke speaks: (Full text) In my opinion, this is a major speech, and therefore I quote more extensively today than usual. You really should read it all.

It is reasonably clear that the U.S. economy is entering a period of transition. For the past three years or so, economic growth in the United States has been robust, reflecting both the ongoing re-employment of underutilized resources as well as the expansion of the economy’s underlying productive potential, as determined by factors such as productivity trends and the growth of the labor force. Although we cannot ascertain the precise rates of resource utilization that the economy can sustain, we can have little doubt that, after three years of above-trend growth, slack has been substantially reduced. As a consequence, a sustainable, non-inflationary expansion is likely to involve some moderation in the growth of economic activity to a rate more consistent with the expansion of the nation’s underlying productive capacity. It bears emphasizing that productivity growth seems likely to remain strong, supported by the diffusion of new technologies, capital investment, and the creative energies of businesses and workers. Thus, productive capacity should continue to expand over the next few years at a rate consistent with solid growth of real output.

...A slowing of the real estate market will likely have the effect of restraining other forms of household spending as well, as homeowners no longer experience increases in the equity value of their homes at the rapid pace seen in recent years.

Gains in payroll employment in recent months have been smaller than their average of the past couple of years, and initial claims for unemployment insurance have edged up. These developments are consistent with the softening in the pace of overall economic activity that seems to be under way. That said, going forward, relatively low unemployment and rising disposable incomes may counter to some extent the factors tending to restrain household spending.

...

Consumer price inflation has been elevated so far this year, due in large part to increases in energy prices. Core inflation readings--that is, measures excluding the prices of food and energy--have also been higher in recent months. While monthly inflation data are volatile, core inflation measured over the past three to six months has reached a level that, if sustained, would be at or above the upper end of the range that many economists, including myself, would consider consistent with price stability and the promotion of maximum long-run growth. For example, at annual rates, core inflation as measured by the consumer price index excluding food and energy prices was 3.2 percent over the past three months and 2.8 percent over the past six months. For core inflation based on the price index for personal consumption expenditures, the corresponding three-month and six-month figures are 3.0 percent and 2.3 percent. These are unwelcome developments.

...Finally, some survey-based measures of longer-term inflation expectations have edged up, on net, in recent months, as has the compensation for inflation and inflation risk implied by yields on nominal and inflation-indexed government debt. As yet, these expectations measures have remained within the ranges in which they have fluctuated in recent years, but these developments bear watching.

With the economy now evidently in a period of transition, monetary policy must be conducted with great care and with close attention to the evolution of the economic outlook as implied by incoming information. Given recent developments, the medium-term outlook for inflation will receive particular scrutiny. There is a strong consensus among the members of the Federal Open Market Committee that maintaining low and stable inflation is essential for achieving both parts of the dual mandate assigned to the Federal Reserve by the Congress. In particular, the evidence of recent decades, both from the United States and other countries, supports the conclusion that an environment of price stability promotes maximum sustainable growth in employment and output and a more stable real economy. Therefore, the Committee will be vigilant to ensure that the recent pattern of elevated monthly core inflation readings is not sustained.

Toward this end, and taking full account of the lags with which monetary policy affects the economy, the Committee will seek a trajectory for the economy that aligns economic activity with underlying productive capacity. Achieving this balance will foster sustainable growth and help to forestall one potential source of inflation pressure. In addition, the Committee must continue to resist any tendency for increases in energy and commodity prices to become permanently embedded in core inflation. The best way to prevent increases in energy and commodity prices from leading to persistently higher rates of inflation is by anchoring the public’s long-term inflation expectations. Achieving this requires, first, a strong commitment of policymakers to maintaining price stability, which my colleagues and I share, and, second, a consistent pattern of policy responses to emerging developments as needed to accomplish that objective.

David Altig updated his probability charts after the employment report last Friday. The fed funds futures market, as I have said before, is getting whiplash. Today's remarks by Bernanke will likely spin the market back in the other direction. The IEM, on the other hand, has remained remarkably calm. As for my take, I think Bernanke's words were appropriate for the situation. I have not wavered from my assertion that another increase this month is more likely than not. The IEM puts the odds at about 60:40. I'd put an increase as even a little bit more likely than that. Not a sure thing, but despite the gyrations that data dependence has caused, I'm staying the course.

In the coming days there will be much to talk about, I am sure.

UPDATE: Whiplash, indeed. This just in from Reuters.

Short-term interest rate futures markets took the comments to mean the Fed was more likely to lift rates at its policy-making meeting this month, moving prices to imply a 76 percent chance of another hike from less than 50 percent before the speech. U.S. stock and bond markets also declined.

Read on.

For the first time in two years we enter the period between FOMC meetings not knowing whether a rate increase is coming. It would indeed be foolish to think that the Fed is finished raising rates for this cycle. One can easily imagine scenarios where we see one or even two more increases before this fall. The language in the FOMC statement is new, however:

The Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives.

In other words, welcome to the world of data dependence. Notice also that there is nothing in the statement about the risks to price stability and sustainable growth being in balance. Last Friday's employment report notwithstanding, the Fed seems fairly confident in the ability to economic growth to continue. The FOMC's opening paragraph states:

Economic growth has been quite strong so far this year. The Committee sees growth as likely to moderate to a more sustainable pace, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.

Despite what a lot of people would have expected, the stock market has barely budged. They seem to be taking the news like grown-ups. That's good to see. Maybe Bernanke is getting through to them after all. Even the 10 year bond is up 2/32. From certain corners comes a sigh of relief that the Fed hasn't gone "dovish" on us.

Indeed they have not. I wouldn't be at all surprised to see another increase in June. Neither would King. It's just that now it's not a sure thing. It's about to get a little more exciting for Fed watchers than it has been in the last two years--more exciting than it has been since I started this blog. Throw away the record books--it's a new ball game. None of us knows what will happen in June, but each data point tightens the noose one way or the other. I will say that I think the bias is still towards a little more tightening. I'm inclined to expect another increase unless a preponderance of data points the other way. If the data remains status quo, then onward we climb--at least for a while.

UPDATE: Mark Thoma remarks:

The bottom line? I expect a pause at the next meeting if the Fed observes signs of the anticipated slowdown and if inflation remains moderate. However, they are very careful to signal that nothing is set in stone, the next move will depend critically on observations of the current and expected future state of the economy.

The question is how much of a slowdown and what level of inflation would trigger a pause? There will be no new GDP data before the next meeting, though there are other monthly indicators such as industrial production, manufacturers orders, sales, and inventories that will be important. There's only one employment report between now and the next meeting, and I don't think that they will pin everything on that. Inflation, I think it is safe to say, is the main point. There are a number of ways to look at it, and that should keep us busy for a few weeks.

UPDATE 2: David Malpass of Bear Stearns writes in the Wall Street Journal that the Fed should have been more aggressive in 2005 and now they're paying the price. In his mind, it has everything to do with the strength of the dollar.

Read CNBC's version--after all, they are part of the story...

Federal Reserve Chairman Ben Bernanke -- via CNBC's Maria Bartiromo -- managed to shock the financial markets into a pullback this afternoon.

Bartiromo, on CNBC's "Closing Bell," said the Fed boss told her at the White House Correspondents Dinner on Saturday night that the markets misunderstood him last week to say the Fed is done raising interest rates.

Bernanke told Bartiromo he found it "worrisome" that anyone would think of him as dovish. He said that he and members of the Federal Open Market Committee, the Fed's rate-setting body -- were trying to create flexibility so the Fed can choose whether to rates or not.

See also: Calculated Risk and Big Picture.

Vindication is always nice. I said last week, among other things, that Bernanke's comments were "necessary...but not sufficient" for a pause. I think the market overreacted and today they got their hand slapped. Dave Altig's probability charts are probably getting whiplash, but such is life on the knife's edge.

As for Bernanke giving an exclusive market moving story to Bartiromo--and let's be honest, that's what it was--I'm not crazy about that at all. That's about all there is to say about it.

Mr. Bernanke speaks:

The FOMC will continue to monitor the incoming data closely to assess the prospects for both growth and inflation. In particular, even if in the Committee's judgment the risks to its objectives are not entirely balanced, at some point in the future the Committee may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook. Of course, a decision to take no action at a particular meeting does not preclude actions at subsequent meetings, and the Committee will not hesitate to act when it determines that doing so is needed to foster the achievement of the Federal Reserve's mandated objectives.

The only thing that would be more clear would be if he had a timeline for "some point in the future." June or August are, of course, the obvious possibilities.

From the blog archives, after the March 28 (last FOMC meeting) I said,

Nothing in the press release surprises me (or changes my outlook), but I look forward to the next round of "Fedspeak" to see which way some committee members will be heading as they go forward. Another increase in May appears very likely. After that it's hard to say. "Some further policy firming" allows some flexibility. Just remember, a pause doesn't mean that it's over. As we near the top, there is something to be said for putting twelve weeks between rate increases rather than six. (Sort of like letting up the pressure on the brake pedal of a car as you come to a stop.) But for the moment, the timing of the inevitable pause is still unknown. Stay tuned for the next round of speeches by FOMC members.

I still like my brake pedal analogy.

And from a Wall Street Journal Econoblog with Tim Duy last November, Tim said:

...Although there may be pressure to establish his [Mr. Bernanke's] inflation-fighting credentials, he will have to weigh this against the actual and projected state of the economy. Regardless of the pressures he faces, over-tightening in the face of deteriorating economic data could be as damaging to his credibility and that of the institution as a whole, as failing to tighten sufficiently as inflationary forces mount. So no, I don't believe that Mr. Bernanke is destined act in deference to his critics.

Still, even if Mr. Bernanke is immune from his critics' pressure, there remains a risk of policy error. As the federal-funds rate is pushed further into the 4% range, we will be closing in on the neutral point for monetary policy. A considerable amount of accommodation has been removed, and recent and expected rate hikes have yet to work their way into the economy. With the Fed seemingly locked on a higher rate trajectory, there will be a risk that past rate hikes will be slowing economic activity even as more tightening is implemented.

The Fed is cognizant of this risk and, I believe, will likely require a higher bar for rate hikes at some point early next year. The real trick for Mr. Bernanke might be the need to communicate the transition to a new policy direction at the same time the Fed is transitioning to new leadership.

and I replied...

If incoming data forces us to redefine "neutral" as something higher, then (all other things being equal) I am slightly less worried than I was this summer about policy error. What concerns me more is, as you suggest, the need to communicate the transition to a new policy, especially if the economy begins to slow and the Fed is forced into some tough choices. If GDP growth slows at the same time that the recent increases in energy prices finally feed through and increase core inflation, the Fed must decide which objective is the most critical. If you advocate inflation targeting (or price-level targeting -- Angry Bear and macroblog have a couple of good posts discussing the difference), your choice is clear. I sense that some of the more vocal opposition to Mr. Bernanke is coming from ardent proponents of price-level targeting who fear that he may not be tough enough.

Still true. Incoming data has pushed the definition of "neutral" higher than it was in November when we wrote this. Sustained increases in energy prices are beginning to show evidence of feeding core inflation. In the morning, perhaps by the time you read this, we'll know how the GDP numbers change this landscape.

Barry Ritholtz is worried that the Fed could get behind the inflation curve. Though I acknowledge the risk, I'm a bit less concerned. Remember, there are two months, and therefore two inflation data points, before the June meeting. I'll be the first to say that if those two points yield unhappy news, I'd call for (and expect) more increases in June and August. Ditto if the morning news reports robust GDP growth. But that's what "data dependent" means. And I reiterate what I said in March. I would not want a pause to mean a stop. I'm definitely not advocating (or expecting) "one-and-done". I'm still of the mind that talk of rate increases will be on everyone's lips well into the fall, even if rates are not raised at every single meeting between now and then. Bernanke's comments today were, I think, a necessary step to pave the way for a pause, but not sufficient to guarantee that it will come in any definite time frame.

I must say though, Bernanke's comments notwithstanding, I can't envision a pause in June if inflation numbers for April and May are what they were for March. But I am on the edge of my seat waiting for the GDP numbers in the morning--more than I have been in some time. Such is life in a "data dependent" environment. Though you'll probably first read this after the morning news, I figured I'd set this out now to give you a clear "before and after."

See you in the morning.

The minutes of the March meeting are out.

Reuters has the story.

Barry Ritholtz says, "We remain as data dependent as ever..." Can't say I disagree with that.

Dave Altig checks out the probability charts and sees a slight, but discernable, shift in the air.

Mark Thoma quotes from Janet Yellen's speech.

It did seem to me that the minutes went into a lot of detail on the discussions of how to word the statement and the fact that the FOMC members realize just how much the market makes out of these statements. For example, take a look at this passage:

Changes in the sentence on the balance of risks to the Committee's objectives were discussed. Several members were concerned that market participants might not fully appreciate the extent to which future policy action will depend on incoming economic data, especially when an end to the tightening process seems likely to be near. Some members expressed concern that retention of the phrase "some further policy firming may be needed to keep the risks...roughly in balance" could be misconstrued as suggesting that the Committee thought that several further tightening steps were likely to be necessary. Nonetheless, all concurred that the current risk assessment could be retained at this meeting.

Given that the intermeeting release of the minutes is now part of the information cycle, it is not out of line to think that this could be warming us up for a change in the language--possibly, but not certainly, at the May meeting. But it does seem clear that a pause in the rate hikes is coming soon--they just aren't quite ready to telegraph to the markets exactly when. To do so would inhibit their flexibility in either direction.

Barry is right. We are as data dependent as ever. Even more so.

Dallas Fed President Richard Fisher thinks so:

Until recently, the econometric calculations of the various capacity constraints and gaps of the U.S. economy were based on assumptions of a world that exists no more. [Former Fed Governor Laurence] Meyer’s book is a real eye-opener because it describes in great detail the learning process of the FOMC members as the U.S. economy entered a new economic environment in the second half of the 1990s. At the time, economic growth was strong and accelerating. The unemployment rate was low, approaching levels unseen since the 1960s. In these circumstances, inflation was supposed to rise—if you believed in the Phillips curve and the prevailing views of potential output growth, capacity constraints and the NAIRU. That is what the models used by the Federal Reserve staff were saying, as was Meyer himself, joined by nearly all the other Fed governors and presidents gathered around the FOMC table. Under the circumstances, they concluded that monetary policy needed to be tightened to head off the inevitable. They were frustrated by Chairman Greenspan’s insistence they postpone the rate hikes.

We now recognize with 20/20 hindsight that Greenspan was the first to grasp changes in the traditional relationships among economic variables. The former chairman understood the data and the Fed staff’s modeling techniques, but he was also constantly talking—and listening—to business leaders. And they were telling him they were simply doing their job of seeking any and all means of earning a return for shareholders. At the time, they were being enabled by new technologies that enhanced productivity. The Information Age had begun rewriting their operations manuals. Earnings were being leveraged by technological advances. Productivity was surging. Inflation wasn’t rising. Indeed, it just kept on falling.

If the advice of Meyer and the others had prevailed, the Fed would have caused the economy to seriously underperform. According to some back-of-the-envelope calculations by economists I respect, real GDP would have been lower by several hundred billion dollars. Employment gains would have been reduced by perhaps a million jobs. The costs of not being right on the critical calibrations of monetary policy would have been huge.

We live in a globalizing era. Just consider what the fall of the Soviet Union, the implementation of Deng Xiaoping’s “capitalist road” in China and India’s embrace of market reforms mean to business operators. Consider labor alone. In the early ’90s, the former Soviet Union released millions of hungry workers into the system. China joined the World Trade Organization at the turn of the century and injected 750 million workers into play. And now India, with over 100 million English-speaking workers among its 1 billion people, has joined the game. Just two weeks ago, a CEO told me his company posted ads for people to apply for 9,000 jobs in a new facility in India. Do you know how many applications they received?—1,400,000.

How does this affect the American manager—paid to enhance returns to shareholders by growing revenues at the lowest possible costs? Because labor accounts for, on average, about two-thirds of the cost of producing most goods and services, the managers will go where labor is plentiful and cheapest. They will have a widget made in China or Vietnam, or a software program written in Russia or Estonia, or a center for processing calls or managing a back office set up in India.

...

You could sense something was wrong with the econometric equations if you listened to the troops on the ground, fighting in the trenches of the marketplace. This is what I did at the U.S. Trade Representative’s office in negotiating market-opening trade rounds with China, Vietnam, Mexico, Brazil and others. It is what my colleagues and I at Kissinger McLarty did while advising dozens of U.S. companies seeking entry into China and the former Soviet satellites and India and Latin America. It is what my colleagues and I on the FOMC do by making dozens upon dozens of calls to CEOs, COOs and CFOs of businesses, large and small, every month to prepare for FOMC meetings.

We are simply observing managers at work expanding the capacity of our economy, expanding the gap between what their previously limited resources would allow them to produce and what their newly expanded globalized, technologically enhanced reach now allows them to produce.

From this, I personally conclude that we need to redraw the Phillips curve and rejig the equations that inform our understanding of the maximum sustainable levels of U.S. production and growth. How can economists quantify what the U.S. can produce with existing labor and capital when we don’t know the full extent of the global labor pool we can access? Or the totality of the financial and intellectual capital that can be drawn on to produce what we produce?

Jeffrey Lacker of the Richmond Fed also gave a speech today. See Mark Thoma's recap. Lacker sounds confident that inflation is under control, and he's upbeat on the overall economic growth picture. Fisher's speech quoted above suggests that globalization is keeping inflation down. Note how he also references the debates within the Fed from the '90s that put Governor Meyer and Chairman Greenspan at odds over interest rates. It's not hard to tell whose camp he's in.

How's the media interpreting this? Here's a check of Reuters:

"The combination of a decline in oil prices, however slight, and some fairly upbeat comments (by Fed officials), may have led Fed watchers to conclude the Fed may raise interest rates at its meeting in May, and then stop," said Hugh Johnson, chief investment officer of Johnson Illington Advisors.

"Conclude" might be a bit strong at this point. Personally, I would probably advocate pausing in June, even if only just for one meeting. However, I'm not prepared to call it anything but an even bet at this point. The markets, at least as of Monday, would seem to concur (hat tip to macroblog). David's comment about the employment numbers coming out on Friday seems on the mark. Also between now and June we'll get two news releases on 1st quarter GDP. I'm not going to "conclude" anything for a while.

But Lacker and Fisher have staked their ground. Let's see how the others position themselves.

I wrote in September concerning the fed funds rate...

Now, 5% by summer is a real possibility, and if someone gave me even money on an over/under bet, I'd have to give serious consideration to "over".

That quote could have just as well been from yesterday (as long as you consider summer starting after the June meeting).

If you're surprised, you haven't been paying attention. Link to press release:

The slowing of the growth of real GDP in the fourth quarter of 2005 seems largely to have reflected temporary or special factors. Economic growth has rebounded strongly in the current quarter but appears likely to moderate to a more sustainable pace. As yet, the run-up in the prices of energy and other commodities appears to have had only a modest effect on core inflation, ongoing productivity gains have helped to hold the growth of unit labor costs in check, and inflation expectations remain contained. Still, possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures.

The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.

The 2nd paragraph is unchanged from January. The first has some differences. The opening sentence about GDP makes sense, but the "special factors" phrase is a little vague. It sounds as if the FOMC is trying to signal that we could be experiencing a "soft landing." Aside from a couple of minor word changes and the addition of "other commodities" in the sentences about inflation, that portion of the statement is little changed.

Nothing in the press release surprises me (or changes my outlook), but I look forward to the next round of "Fedspeak" to see which way some committee members will be heading as they go forward. Another increase in May appears very likely. After that it's hard to say. "Some further policy firming" allows some flexibility. Just remember, a pause doesn't mean that it's over. As we near the top, there is something to be said for putting twelve weeks between rate increases rather than six. (Sort of like letting up the pressure on the brake pedal of a car as you come to a stop.) But for the moment, the timing of the inevitable pause is still unknown. Stay tuned for the next round of speeches by FOMC members.

FIrst a couple of links to get you warmed up... Louis Uchitelle writes for the Times, summarizing the lay of the land. Greg Ip for the WSJ is on top of things as usual. Reuters has bullet points suitable for your macro class.

From Greg Ip's article:

But as to what happens after [Tuesday's meeting], it's still largely guesswork. The market puts high odds on another boost to 5%, but Mr. Bernanke said nothing to shade those odds. Indeed, in his five major appearances as chairman, he has either steered away from current commentary, or presented such a balanced view that markets have barely moved.

As chairman, concluded Bank of America economist Peter Kretzmer, "Bernanke may be no easier to decipher than his predecessor." The words may be clearer, but clarity does not equal candor.

Yet Mr. Bernanke's refusal to guide the markets may be temporary. Whatever his personal preference on interest rates, Mr. Bernanke has a powerful reason to keep them to himself for a little longer. To signal how the FOMC should vote without yet leading a meeting could strike the 18 other members as presumptuous and strain relations with them early in his term. (Two of them -- Vice Chairman Roger Ferguson and Philadelphia Fed President Anthony Santomero -- are resigning soon, and as is customary for FOMC members, will not attend their last meeting; an alternate will serve in Mr. Santomero's place. Their successors have yet to be named.)

Very true. Sorry to disappoint you, but I don't see any big revelations coming tomorrow. What you see will probably be consistent with the notion of at least one more rate increase... or not. I'd say another increase at the May meeting is quite likely unless we learn next month that 1st quarter GDP tanked (which I don't think is very likely). Past that, as Dave Altig says, the race is "wide open."

But as for tomorrow, even Greg Ip is willing to hedge his bets a little...

Brian Sack used to work at the Fed and co-wrote, with Mr. Bernanke and another staffer, a study that established the benefits of the Fed's guidance. Now at the private forecasting firm Macroeconomic Advisers, Mr. Sack says: "The markets have a thirst for direction, and it can't always be satisfied. But at times when Bernanke has a different view than what seems priced into the market, he will not shy away from conveying that view, and on those occasions, he will certainly move markets."

Who knows? It could happen Tuesday.

That's probably a good way to leave things until tomorrow.

From the press release:

Roger W. Ferguson, Jr., submitted his resignation Wednesday as Vice Chairman and as a member of the Board of Governors of the Federal Reserve System, effective April 28, 2006.

Ferguson, who has been a member of the Board since November 5, 1997, submitted his letter of resignation to President Bush. He will not attend the March 27-28 meeting of the Federal Open Market Committee.

"Roger has made invaluable contributions to the Federal Reserve and to the country," said Federal Reserve Board Chairman Ben S. Bernanke. "He led the Fed's first response to the 9/11 terrorist attacks, was a strong advocate for increased transparency of monetary policy, and ably represented the Federal Reserve in important international fora. I value his friendship and counsel greatly and wish him all the best in his new endeavors."

Ferguson, 54, was first appointed to the Board by President Clinton to fill an unexpired term ending January 31, 2000. He was then appointed by President Bush to a full term that expires on January 31, 2014.

Ferguson is the last member of the Board who was not originally appointed by President Bush.

Mr. Ferguson was involved in a number of important activities while at the Fed. His work has largely been in the area of payments systems and financial stability. It's important work that perhaps does not always get the attention it deserves. As the senior member on the Board, his institutional experience will be missed as well.

Here is an interview with Mr. Ferguson that the Minneapolis Fed published back in 2000.

Things are extremely busy around here. Links only today.

The FOMC Minutes

The money quote:

In the Committee's discussion of monetary policy for the intermeeting period, all members favored raising the target federal funds rate 25 basis points to 4-1/2 percent at this meeting. Although recent economic data had been uneven, the economy seemed to be expanding at a solid pace. Members were concerned that, even after their action today, possible increases in resource utilization and elevated energy prices had the potential to add to inflation pressures. Although the stance of policy seemed close to where it needed to be given the current outlook, some further policy firming might be needed to keep inflation pressures contained and the risks to price stability and sustainable economic growth roughly in balance. In the view of some members, the possibility of additional policy moves was reinforced by readings on core inflation and inflation expectations that were somewhat higher than was desirable over the long run. However, all members agreed that the future path for the funds rate would depend increasingly on economic developments and could no longer be prejudged with the previous degree of confidence.

And of course...

As this meeting marked Alan Greenspan's last as a member of the Committee, meeting participants took the opportunity individually and collectively to pay tribute to his many years of outstanding service to the Federal Reserve and to the nation. They expressed their appreciation for his collegial and successful leadership of the Committee and of the Federal Reserve System and emphasized the privilege and honor they felt in having served with him.

Wall Street Journal's take (subscription required)

Reuters article

Introductory remarks posted on Fed's website.

For the first time in almost 20 years, a new face greeted the House Financial Services Committee for the semi-annual monetary policy testimony. Overall, it was an engaging session. Chairman Bernanke was upbeat about the prospects for the economy in 2006 and 2007, tipping his hand a bit about the potential for even higher short term interest rates. He also pointed to the greater stability of the U.S. economy as being partly responsible for keeping long term inflation expectations (and therefore long term interest rates) in check.

The questioning is always the more interesting part of the session. His responses were brief and straightforward--a departure from the responses of his predecessor that was noticed by the committee. He answered questions on fiscal policy by pointing out that it is Congress's responsibility to choose the size of government and that tax revenues should reflect that choice. Some of his questioners on the committee might see this as taking the safe way out, but others outside the committee, myself included, find this approach preferable to having the Fed chair offer specific recommendations on fiscal policy.

He was well-prepared, almost scripted, for questions about the discontinuance of M3 and on his statements on inflation targeting. On questions of income inequality and wages, there was candor without offering specific policy recommendations. Overall, there was an air of openness throughout the questioning, but it was tempered by appropriate respect on Mr. Bernanke's part for the role of Congress in policy matters. Mr. Greenspan is a tough act to follow, and the committee had developed a unique relationship with the former Fed chairman. Nonetheless, I think the committee might have come away from today's testimony with a positive outlook on the relationship they will have with Mr. Bernanke over the next few years.

UPDATE: The Wall Street Journal quotes the last paragraph above along with statements from many other economists both business and academic. Most of the comments have to do with insights into the future of monetary policy that we might have gleaned from today's testimony. For example,

[Bernanke] is learning that Mr. Greenspan's Greenspeak, a totally dense and largely indecipherable approach to answering questions, really is required when dealing with Congress. So much for being clear. Being clear only gets you into trouble. So, what should we take away from the testimony? Mr. Bernanke believes that inflation is job one now and always. So, if there is to be a mistake made, it will be on the side of lower not higher inflation and therefore more rather than less tightening. -- Joel L. Naroff, president and chief economist, Naroff Economic Advisors

and...

No surprises today: He struck a hawkish tone, as expected. This is consistent with what we heard from his warm-up acts last week. Chicago Fed Prez Michael Moskow and Dallas Fed Prez Richard "8th Inning" Fisher struck similar notes. Moskow suggested that rates are "historically low," that inflation was "creeping into the core" CPI rate, and suggested that rates may need to "rise further beyond neutral" to kill inflation. We listened hard as we could to the new Fed head, but were unable to discern anything inconsistent with Moskow's speech. Bernanke stated that "resource utilization was rising, cost pressures increasing, and short-term interest rates still relatively low." That hardly implies a Fed nearly finished with their tightening cycle. -- Barry Ritholtz, Ritholtz Research; blog: The Big Picture

Naroff and Ritholtz are right on the money, but as Ritholtz says, "No surprises." I saw nothing in the prepared remarks or the questioning that causes me to alter my opinion on where the Fed is going to take interest rates. Wall Street took a while to parse it all and at the moment appears to have reached the same conclusion.

The question/answer period is always more interesting, and even more so for a new chair. Kash Mansori likes what he heard.

Bernanke generally provided answers about numerous topics (e.g. the deficit, the minimum wage, trade protection, the regulation of Fannie Mae, R&D, personal saving) that a large majority of professional economists would probably agree with. In that sense, I think that he will be a good representative of the profession's consensus, to the degree that there is one. And for the most part, I think that's probably a good thing in the world's most powerful central banker.

And that is precisely why I found myself nodding my head several times during the question/answer session. Bernanke gave answers that I would be comfortable giving in class or in an interview. On balance I do agree that is a good thing, and I think he will wear it well. But Mr. Bernanke will always have to remember that good academic answers don't always go over well in the media. Just ask Greg Mankiw.

Tomorrow, the Senate. I think Bernanke has set a good benchmark upon which to build his reputation going forward.

I'm talking about the fed funds probabilities, of course. Yes, for March it's been a foregone conclusion. But the May probabilities have been hovering around 50-50 until the first couple weeks of this month. Read the details at macroblog.

Bloomberg reports that the nomination of Kevin Warsh to the Board of Governors of the Fed is drawing some fire. (Hat tip: Division of Labour)

Feb. 10 (Bloomberg) -- Most of President George W. Bush's nominees to the Federal Reserve have earned accolades from across the economic and political spectrums.

And then there's Kevin Warsh.

Bush's nomination of the 35-year-old White House aide -- a lawyer by training who would become one of only two members of the Fed's seven-member board of governors without a Ph.D. in economics -- has been greeted by criticism and bewilderment by some former Fed officials and economists. They point to his political connections and inexperience, and say the White House could have found a better-known, more qualified choice.

``Kevin Warsh is not a good idea,'' said former Fed Vice Chairman Preston Martin, who was appointed by Ronald Reagan in 1982. ``If I were on the Senate Banking Committee,'' which must approve Fed nominees, ``I would vote against him.''

The same article also makes the following observation:

If Warsh and Kroszner are confirmed, Bush will have appointed all seven members of the Fed board.

True, but Roger Ferguson was appointed by Clinton to fill an unexpired term. Bush renewed him to a full term. The others... all Bush.

I expressed my confusion about the Warsh nomination at the time the news came out, saying I wasn't entirely sure what to make of it. I don't know what his views on monetary policy are. But the president has the right to appoint someone who he thinks will bring certain talents to the Board. There is no requirement that all the members be top-flight academic monetary economists. (Assuming Randall Kroszner is confirmed that would give us two high profile academics. Susan Schmidt Bies was in academia in the 1970s as well.) So I'm inclined to reserve final judgement until the hearings. But if I were on that committee I'd have some questions. I hope there will be some tough questions, because I'm still a little confused.

But should I get my hopes up for an in-depth inquiry into his qualifications, experience, and views on the economy? The article concludes,

While little is known publicly about Warsh's views on such Fed concerns as inflation, employment growth and the global economy, hearings on the nomination that are scheduled for Feb. 14 may shed more light. In any event, Senator Richard Shelby, the Banking Committee chairman, said in an interview that he expects an easy confirmation.

``He's very smart,'' the Alabama Republican said. ``He'll sail through.''

Necessary, but not sufficient.

UPDATE: Mark Thoma has a similar reaction.

UPDATE: Kip Esquire has more. Comments at Economist's View are decidedly negative. I think anyone nominated deserves a chance to sit in the hot seat. If I were on the committee I'd ask tough questions and if I didn't get good answers, I'd vote no. It's as simple as that. Same as I would say for anyone whose qualifications were unclear. I sure hope C-Span carries the hearings. It could be interesting.

The Homer Jones Memorial Lecture sponsored by the St. Louis Fed and a number of St. Louis area universities is on March 8 this year. (Click for details) Jerry Jordan will be speaking on "Money and Monetary Policy in the 21st Century."

Last year, I remarked in the blog with some dismay that I was not able to attend Ben Bernanke's lecture.

Marking it on my calendar now...

The funds rate did go up another 25 basis points. The press release from the FOMC meeting contains only three differences from the last one. (New language in bold.)

Although recent economic data have been uneven, the expansion in economic activity appears solid. Core inflation has stayed relatively low in recent months and longer-term inflation expectations remain contained. Nevertheless, possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures.

The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.

"Measured" is gone from the first sentence of paragraph two. Not much to say about it--we knew it would happen sooner or later (click here and here).

The language about the uneven data is no doubt a reference to Friday's GDP report. And finally, the word "may" in the first sentence of paragaph two replaces the words "likely to be". I interpret "may" is being somewhat weaker.

The door is open for leaving rates unchanged in March or May, however, on the March meeting, I would still lean to an increase as being more likely than not. The May meeting is really a coin toss at this point.

UPDATE: In other news, Ben Bernanke was confirmed by the Senate. This Reuters story does not give the vote details as to how many voted against confirmation.

WASHINGTON (Reuters) - The U.S. Senate on Tuesday confirmed White House adviser Ben Bernanke as chairman of the Federal Reserve, clearing him on Alan Greenspan's last day in office to take over America's most powerful economic post.

The Senate approved the former Fed governor on a voice vote.

He enjoyed strong support from both Republicans and Democrats, however Sen. Jim Bunning, a Kentucky Republican, spoke in opposition to the nomination, complaining that Bernanke would too closely follow Greenspan's policies.

Some senators do not keep up with the Fed confirmation hearings. (NY Times)

Wall Street may be intensely interested in just about every word ever uttered by Mr. Bernanke, the former Princeton economist and chairman of the White House Council of Economic Advisers who is President Bush's choice to succeed Alan Greenspan.

But in Washington, he is barely on some people's radar screens. Indeed, here is what Senator George Allen of Virginia, who is considering a bid for the Republican presidential nomination in 2008, said when asked his opinion of the Bernanke nomination.

"For what?"

Told that Mr. Bernanke was up for the Fed chairman's job, Mr. Allen hedged a little, said he had not been focused on it, and wondered aloud when the hearings would be. Told that the Senate Banking Committee hearings had concluded in November, the senator responded: "You mean I missed them all? I paid no attention to them."

Later in the article...

Economists are a bit mystified, though not entirely surprised. The Alito hearings were brimming with controversy, from the judge's membership in a Princeton University alumni group that fought against affirmative action to a 20-year-old memorandum in which he said that the Constitution did not provide a right to an abortion.

The Bernanke hearings, by contrast, centered on the world of monetary policy, a field where most of the big ideological fights were settled long ago.

Perhaps some of my esteemed readers would disagree with that! Actually, I think the writer is just oversimplifying the following remark by Alan Blinder.

"Monetary policy has become much less political than it used to be years back and centuries back," said Alan S. Blinder, a former Fed vice chairman who is a professor of economics at Princeton, where he was a colleague of Mr. Bernanke's. "There's a consensus on what monetary policy should be doing, which is to say keeping inflation low and, subject to that constraint, keeping employment high. So politicians take this attitude that it's for technocrats, and it doesn't matter too much whether the guy is a Republican or a Democrat."

That's a pretty broad statement, but essentially correct as far as it goes. There are a lot of things I look for in a Fed chair, but party affiliation isn't one of them. But taking it at face value, if it really is the case that party affiliation doesn't matter much, and that is why the some senators are uninterested, I think that says more about those senators than it does about monetary policy.

The Wall Street Jounal's Greg Ip has the insight to ask this important question. (Subscription required)

Though a highly respected economist, Mr. Bernanke won't initially command the deference that Alan Greenspan earned during more than 18 years as chairman. With his colleagues expecting to contribute more, Mr. Bernanke may face a delicate tradeoff when they disagree. He might compromise, which could damp his influence over the Fed's message. Or he could decide to impose his views, which could provoke dissents and raise questions about his authority.

Fed officials say the increase in internal democracy is both inevitable and constructive, and has led to more collegial policy making. The Fed's tradition of deciding by consensus is well entrenched, they say. Some officials say an increase in formal dissents would even be healthy. At turning points in the economy, they could reveal honest disagreements among officials on difficult questions.

...

An early glimpse of this democracy in action unfolded late last year in the run up to the Fed's Dec. 13 policy meeting. Virtually all Wall Street economists expected the Fed to raise interest rates by a quarter of a percentage point. Still unclear, however, was whether the Fed would signal a change in the future course of rates.

For FOMC members, most of the suspense ended long before they gathered around a huge conference table at Fed headquarters in Washington, D.C., according to people familiar with the process. About a week earlier, the five Fed governors and 12 regional reserve bank presidents who participate in committee decisions had received three drafts of the statement from the Fed's staff.

A debate ensued, these people say. Several presidents circulated extensive comments via encrypted email. By the day of the meeting, the FOMC had largely agreed on what the statement should say. The key point: it would no longer call interest rates "accommodative" -- a broad hint that rate increases could soon come to a halt.

I have to say that I'm not that surprised that these discussions are taking place. In order to get the statement out right after the meeting (and the minutes out after only 3 weeks--more on that in the article) there would have to be pre-meeting discussion or people are going to feel like they are not part of the process. Bernanke will need to manage that process in a way that no other new chairman has. Things were a lot different when Greenspan came on board in 1987.

There's a lot more in the article, including how Alan Greenspan managed dissent over his 18+ years at the helm. There is some interesting discussion of the changing role of the reserve banks and their presidents over the years as well. This is definitely a good read to start out your week on the eve of Greenspan's last FOMC meeting.

Greg Ip and John D. McKinnon write in the Wall Street Journal:

The White House announced that President Bush will nominate Kevin M. Warsh, a White House adviser on domestic finance and capital markets, and Randall S. Kroszner, who teaches at the University of Chicago's Graduate School of Business.

...

The nominations come as Alan Greenspan prepares to step down Tuesday after 18½ years as chairman. Ben Bernanke, a monetary economist who is chairman of Mr. Bush's Council of Economic Advisers, is scheduled to succeed him Wednesday. He awaits Senate confirmation, tentatively expected Tuesday.

Mr. Bernanke created one of the vacancies when he quit as a Fed governor to go to the White House last summer. Edward Gramlich, appointed by President Clinton, stepped down as a Fed governor in August.

The nominations would tilt the board's composition toward financial-industry expertise rather than macroeconomics. Mr. Warsh, a lawyer by training, was an investment banker at Morgan Stanley before joining the White House National Economic Council. He has been the White House's point person on financial-industry issues. Mr. Kroszner, who served on the Council of Economic Advisers during Mr. Bush's first term, specializes in banking, banking regulation, international-financial crises and monetary economics.

...

Of the five governors, three have primarily a financial-industry background. Mark Olson was a banker, Capitol Hill aide and consultant. Susan Bies, a Ph.D. economist, was an executive at First Tennessee National Corp., a regional bank. Vice Chairman Roger Ferguson, who has a Ph.D. in economics and a law degree, was a consultant specializing in the financial industry.

Obviously there will be more to write about this over the coming days and weeks. Professor Kroszner is definitely qualified for the post. I'm not entirely sure yet what to make of the Warsh nomination. Expect questions on his experience outside the administration. Some people questioned Ben Bernanke about his ability to distance himself from the executive branch where he had served as an adviser. Admittedly, potential chairmen get more intense scrutiny than a nominee for a governorship. Still, I would expect that people will want to know where Mr. Warsh stands on policy and regulatory issues. I expect an interesting set of hearings, probably not quite at the level of the Alito hearings, but more intense than the typical hearings for a Fed governor.

Tim Duy thinks an inversion is coming. Of course we have already had one kind of inversion, but the kind that Duy is talking about is in the 10 year-fed funds spread. I would definitely agree that it is more likely than not. Duy gets another important thing right as well...

A cessation in rates hikes should not be interpreted as the first step toward cutting rates.

I would only insert the word "temporary" before "cessation" because I would consider it to be temporary until proven otherwise. If the Fed keeps rates constant in March, I would certainly not rule out another increase at the following meeting. Ever since we started talking about when the Fed would "pause" that is exactly how I have characterized it. Unless there is very good evidence to the contrary, I would see it as a "pause" rather than an ending that would presage a decrease as the next move.

Duy also remarks that the Beige Book had "mixed messages." The regional nature of the report does occasionally produce such a result. In any case, there wasn't much in there to change my outlook. Steady as she goes.

Full text from FOMC website.

Excerpts:

In the Committee's discussion of monetary policy for the intermeeting period, all members favored raising the target federal funds rate 25 basis points to 4-1/4 percent. With spending apparently retaining considerable momentum, and with the indirect effects of increased energy prices still threatening to raise core inflation at least for a time, the Committee thought that additional policy firming at this meeting was appropriate to keep inflation and inflation expectations in check. Committee members generally anticipated that policy would likely need to be firmed further going forward. In that process, the Committee would need to be mindful of the lags in the effect of policy firming on the economy. However, it would also have to take account of the effects of the sustained period of favorable financial conditions on asset prices and aggregate demand as well as the resulting possibility of further increases in resource utilization and pressures on prices. Views differed on how much further tightening might be required. Because the Committee's actions over the past eighteen months had significantly reduced the degree of monetary policy accommodation, members thought that the policy outlook was becoming considerably less certain and that policy decisions going forward would depend to an increased extent on the implications of incoming economic data for future growth and inflation.

The Committee agreed that several changes in the wording of the announcement to be released after today's meeting would be appropriate. The federal funds rate had been boosted substantially, and, in the view of some members, it was now likely within a broad range of values that might turn out to be consistent with output remaining close to potential. In these circumstances, the Committee thought that policy should no longer be characterized as accommodative. Members concurred that the statement should note that the expansion remained solid despite elevated energy prices and hurricane-related disruptions. While inflation and long-term inflation expectations remained contained, the Committee agreed that the announcement should indicate that possible increases in resource utilization, as well as elevated energy prices, had the potential to add to inflation pressures and that "some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance." Although future action would depend on the incoming data, this characterization of the outlook for policy was seen by most members as indicating that, given the information now in hand, the number of additional firming steps required probably would not be large. Some members thought that the word "measured" was no longer necessary, but its retention for this meeting was seen as potentially useful to preclude a possible misinterpretation that the Committee now saw a significant possibility of adjusting policy in larger increments in the near future. Wording of the announcement along these lines was not expected to have a substantial effect on market expectations for policy, though such effects were especially difficult to judge given the extensive changes being made to the statement. The members agreed that the announcement should end by noting that policy will respond to changes in economic prospects as needed to foster the Committee's objectives.

See here for the Wall St. Journal's take.

I thought it was worth quoting those two paragraphs so as not to take any part of it out of context. It is interesting to note that they kept the word "measured" in to make sure that no one would think that it meant that rates were about to go up at a higher rate (e.g. 50 basis points). For the moment at least, that seems to be off the table, especially since they mention being mindful of policy lags.

No, the tone now seems to be that most of the heavy lifting is done. That news certainly pleased the stock market. There are still some inflation hawks who would go further, and certainly developments in the incoming data could still push things in that direction--I don't dispute that. Greenspan will hike rates one more time as he leaves. After that, it's an even bet. Dave Altig's implied probability charts showed things moving in that direction a few days ago. I am certainly looking forward to an update. I think it's going to be pretty close for March, maybe 55/45. We'll see.

Nothing too surprising in the minutes. The most interesting part was the discussion of the change in language and possible misinterpretation. The road to transparency is not without bumps.

Elsewhere in the blogosphere, Barry Ritholtz has a pithy summary.

UPDATE: Mark Thoma is more surprised than I was by the "measured" discussion. I can see where they are coming from. It wouldn't have been my interpretation. In fact, I argued against that interpretation back in September. Maybe that's why I'm less surprised.

Bye-bye "measured pace". Bye-bye "accomodation". Hello "measured policy firming". Here's a link to the full FOMC statement, but I am going to quote the two important paragraphs in full. For the record, the FOMC did once again raise the funds rate by 25 basis points.

Despite elevated energy prices and hurricane-related disruptions, the expansion in economic activity appears solid. Core inflation has stayed relatively low in recent months and longer-term inflation expectations remain contained. Nevertheless, possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures.

The Committee judges that some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.

For reference, here is the last statement from Nov. 1.

Elevated energy prices and hurricane-related disruptions in economic activity have temporarily depressed output and employment. However, monetary policy accommodation, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity that will likely be augmented by planned rebuilding in the hurricane-affected areas. The cumulative rise in energy and other costs has the potential to add to inflation pressures; however, core inflation has been relatively low in recent months and longer-term inflation expectations remain contained.

The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.

Unlike past statements where the change of a word or two could be highlighted, this is a substantial rewording.

In particular, the 2nd paragraph puts the focus less on price stability per se. I suppose that will rattle a few chains. The 2nd paragraph sounds more like it is paving the way for a temporary pause in the action with words like "...some further measured policy firming is likely to be needed..." (emphasis mine). Keeping a "measured pace" for so long heightened the possibility of the committee painting themselves into a corner. This language gives them a way out while still maintaining the ability to press on with higher rates if inflation continues to pose a threat. It may take the market a couple days to sort it out, but at first glance, this language could work. I would still like to see it evolve, however.

The first paragraph now contains an inflation warning, "Nevertheless, possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures." Hawkish? Maybe, but that sentence has some qualifiers in it. Again, the tone throughout the statement seems to be one of paving the way for an eventual pause in the rate hikes while maintaining vigilance against inflation.

Enough of what I think. What does the bond market think? At the moment, the bond market is satisfied. They seem to be taking the news well. The 10 year price is up 7/32 as I write. They don't seem to think that the Fed suddenly turned into a dove with this statement. With that as an objective measure of the success of the new language, I'd have to give it a passing grade, perhaps a B+ (lest I be accused of grade inflation.)

UPDATE: For more see: Economist's View, The Big Picture, and possibly more to be added later.

Here's a Reuters story concerning the Fed meeting tomorrow. Not much we haven't already discussed. But in all the talk about "measured," we sometimes forget about the other word that will probably have to go--perhaps tomorrow.

A Reuters survey of Wall Street economists found just over half expect some changes in Tuesday's statement, such as dropping or watering down the reference to "accommodative" policy because rates are no longer clearly boosting growth.

The other critical piece of guidance about future policy -- that rate rises will be "measured" -- is likely to be preserved this month, since at least one more rate rise after December is expected universally by economists and financial markets.

UPDATE: Meanwhile, Tim Iacono, notes that the Bank of New Zealand is raising rates with vigor ("in a way that really hurts" as Governor Alan Bollard put it) and openly discussing the inflationary pressures caused by a booming housing market. Macroblog is planning on a special installment of his fed funds futures probabilities tomorrow.

Greg Ip writes in the Wall Street Journal (full story here)

Since August 2003, the Fed's statement released after each meeting has signaled its next move. Since it began to raise rates from a 46-year low of 1% in June 2004, that statement has described Fed policy as one of "monetary accommodation," meaning rates were below a "neutral" level that neither stimulates nor restrains growth. The statement has also said more "measured" increases were likely, which markets have interpreted as at least one or two more quarter-percentage-point increases.

Given the uncertainty, Fed officials expect to drop or water down their previous language soon. Minutes of the Fed's Nov. 1 meeting, released two weeks ago, showed that "the statement is currently a subject of discussion," Federal Reserve Bank of San Francisco President Janet Yellen said last week. "At issue" are the references to "accommodation" and "measured," she said. "While it seems unlikely that the end of the current tightening phase is yet at hand, there obviously will come a time when these two phrases are no longer appropriate."

The lingering word "measured" reminds me of the old story of the paradox of the unexpected hanging. As the story goes, a condemned criminal is given an unusual sentence by an eccentric judge. He is told that he will be executed sometime next week, but the exact day of the execution will be a surprise. Some versions of the story say that if the prisoner can predict the day of his execution, his sentence will be commuted.

The prisoner reasons that the execution cannot be on Friday becuase if he was still alive on Friday the day would be known with certainty. He reasons that it cannot be on Thursday either since if he were alive on Thursday the execution must be on that day (since Friday is ruled out). Repeating this reasoning (this is called backward induction) the prisoner concludes that the execution cannot happen at all. Satisfied with his reasoning, imagine his surprise when he's led to the gallows at high noon on Wednesday. The judge's sentence was right after all.

It's a paradox.

The word "measured" will not stay in the press statement forever. It has a finite life. For that matter, the interest rate increases will come to an end eventually as well. But when? As it becomes ever clearer that a shift is coming it becomes tricky for the Fed to manage those expectations. They want the flexibility of choosing when to change the policy (or the wording) on their own timetable in response to incoming data without being too hamstrung by market expectations. If they get too predictable, they lose that flexibility. They end up painting themselves into a corner, making the change at the last possible minute (leaving in the word "measured" all the way up to the end of the rate hikes, for example). On the other hand, you don't want to totally surprise the market. It's an even tougher problem than the hangman's paradox.

So how do you maintain your flexibility without introducing too much uncertainty into the bond market? Very carefully. A review of St. Louis Fed president Poole's remarks from this spring are in order. What should the new "stock phrase" be? It needs to have a clear interpretation without being too confining given that we seem to be approaching a shift in policy stance. Comments are open.

UPDATE: Mark Thoma read the same WSJ article and responds,

For now, the problem is how to change or remove the current language without having the market lock into a particular view of future policy. If the market anticipates a particular path as a result of changing or removing the language, say a pause in rate hikes, that would undermine the flexibility altering the language attempts to achieve.

From the NY Times:

WASHINGTON, Dec. 7 (Bloomberg News) - Alan Greenspan, the Federal Reserve's longtime chairman, said Wednesday that it was "unwise" to focus the bank's interest rate policy only on reaching a "neutral" level that neither spurred nor restrained economic growth.

The complications associated with inflation "suggest that reliance on a single summary measure such as a neutral real interest rate would be unwise as a strategy for formulating monetary policy," Mr. Greenspan said in a written response on Nov. 28 to questions submitted by Representative Jim Saxton, chairman of the Joint Economic Committee of Congress, after Mr. Greenspan's testimony on Nov. 3. The panel released the responses on Wednesday.

Further down in the article, it looks like Mr. Greenspan is of the opinion that the solution to the "conundrum" is part savings glut and investment dearth.

Asked why long-term bond and mortgage rates had declined even as the Fed raised short-term rates, Mr. Greenspan said that lower inflation, high global savings and "low levels of intended investment" had pushed down long-term rates worldwide in the last 10 years.

Greg Ip adds a bit concerning the yield curve in the WSJ (subscription required):

In his letter, Mr. Greenspan, as he has in the past, questioned the usefulness of the gap between short- and long-term interest rates, or "yield curve," in forecasting economic growth. Historically, a narrowing of that gap, called a "flattening" yield curve, has foreshadowed slower growth. When short-term rates rise above long-term rates, a recession often follows. The yield curve has flattened significantly in the past year, which some analysts say portends a sharp slowdown.

The full text of the letter is available at the WSJ website.

The Beige Book is out. Follow the link to read the details. Yes, the news is mostly good, but if you read closely, it's not unambiguously so. Conditions are not uniformly good throughout the country, but that might be hard to achieve in the best of times. But where there are soft spots, they are for a specific reason. Case in point,

The Dallas District provided the only indication of lower wage pressures--for the airline industry.

On prices,

Consumer prices remained stable or experienced generally modest increases, but most Districts reported increasing input prices, particularly of energy-related products, construction and raw materials, and transportation. Fuel surcharges have become common in many Districts. In response to higher input prices, some businesses in the New York, Philadelphia, and Richmond Districts were able to pass along a portion of increased costs to consumers. Retail prices in the Boston District remained stable but had risen modestly in the Cleveland, Richmond, Chicago, and Kansas City Districts. Competitive pressures in the Atlanta and Dallas Districts have limited the ability to increase selling prices. Some manufacturers in the Dallas and Minneapolis Districts, however, plan to raise prices in 2006.

On Manufacturing,

Manufacturing activity increased in all Federal Reserve Districts except St. Louis, where activity was mixed.

Real estate is moderating, and labor markets are improving. But the auto sector is not as hot.

With all that good news, all eyes will be on the employment report. If it doesn't hit 200,000 we'll all be scratching our heads over the weekend trying to figure out what to believe.

The discontinuance of M3 has been getting attention, notably from The Prudent Investor and The Big Picture. Mark Thoma and David Altig also mentioned it. Altig, for his part, is not too worried. He looks at the percentage changes in M1, M2, and M3 together.

Let's probe further. Here's a chart, similar to Altig's, but showing only M2 and M3 (M1 behaves a lot differently) just over the last 20 years (a period in which the two series have varied in a fairly stable manner).

Yep. They move together. Now, there looks like there could be a lead/lag relationship that asserts itself from time to time. Might be worth looking at. There is also a small gap that appears to be opening up. That bears watching.

But it would be useful to see if any particular non-M2 component of M3 is driving things. Consider the following chart:

Large time deposits are red "ltd" and repurchase agreements are in black "rp". Eurodollars are in blue. Money market mutual funds in M3 are in green.

First of all, note that some of these components are pretty small, and most are quite volatile. Raw data is from H.6 historical tables from the Fed.

Repurchase agreements jumped in 2002 and 2003, but that coincides with falling M2 and M3. It is possible, of course, that policy lags come into play. However, at the moment, it appears that if there is a divergence in M2 and M3, it's large time deposits causing the divergence in the data. Interesting, but not sinister.

I'm never really happy to see a data series disappear. Continuity of data is important to researchers. But at the same time, I see no evidence that they are covering up something going on with repurchase agreements. After all, system open market holdings, as well as temporary and permanent operations are available on a daily and a historical basis from the New York Fed. RPs along with other factors affecting reserve balances are also published weekly in the H.4.1 release. Nothing says that this will change, so I am under the impression that you will still be able to find the data there.

UPDATE: A commenter asks why I think they are discontinuing M3 (a question I did not address directly above). The truth is, of course, I don't know. As I said above, I'm pretty sure that it's not to try to hide anything, particularly anything nefarious going on with repurchase agreements. If I had to speculate, I'd say it was probably determined that the value of that particular formulation of a monetary aggregate to the Fed was no longer was worth the cost of producing it on a monthly basis and benchmarking it annually.

This has happened before, you know.

I offer the dedicated reader three papers that describe the monetary aggregates from a historical perspective. These papers detail, among other things, the old monetary aggregates (M4, M5, ...) that are no longer reported. As a research point, I think it would be interesting to see some investigation into the behavior of the non-M2 M3 components as I described above. If there is anything useful in there, let's focus on it, and then the world will little remember the precise definition of M3, just like we no longer remember what was in M4 or M5.

The papers:

Anderson, Richard and Kavajecz, Kenneth. A Historical Perspective on the Federal Reserve’s Monetary Aggregates: Definition, Construction and Targeting, St. Louis Fed Review, March/April 1994.

Walter, John. Monetary Aggregates: A User's Guide, Richmond Fed Economic Review, Jan/Feb 1989.

Broddus, Alfred. Aggregating the Monetary Aggregates: Concepts and Issues, Richmond Fed Economic Review, Nov/Dec 1975.

One from the 70's, one from the '80s, and one from the '90s. Read them together and you get a very nice historical overview of the evolution of the aggregates we have today. Maybe the time is right for one from the '00s to explain why M3 is no longer worth publishing. I, for one, would read such a paper with interest.

As I write tonight, I'm listening to the Bernanke confirmation hearings via the C-Span website. It's going as I expected. Sen. Sarbanes held up a chart showing how our unemployement rate is so much lower than Europe's...and of course he reminded us that the European Central Bank has an inflation target.

Mr. Bernanke's response: "Senator, it was below that rate 20 years ago before the ECB was even created. I believe there are other factors that contribute to that difference."

Indeed it was.

Anyway, it's good stuff to have on in the background while blogging.

Barry Ritholtz has been posting about the recent announcement from the Fed that the publication of M3 is going to be discontinued. A comment on Ritholtz's blog (The Big Picture) says that the silence on the econ blogs is deafening.

I've been grading one set of exams and writing another. I promise a post on it later.

Tim Duy wants to avoid being complacent, but feels like he's stuck in a rut.

Little has come to my attention in the past couple of weeks to change my underlying outlook – the Fed will continue to raise rates until they see a clear shift in real activity. In this case, “clear” means “evident in the data,” not anecdotal evidence...

He and I are also on the same page regarding the housing bubble.

Elsewhere, Calculated Risk and Buttonwood are very worried that the Fed will overshoot. With the real fed funds rate still very low, I'm not in the overshooting camp... yet. But can I forsee scenarios that would cause me to switch camps? Yes. The 4th quarter numbers will go a long way in suggesting to me where we are with regard to the overshooting scenario.

But that's just it, isn't it? Waiting for the next data point, letting the inertia build. When I said that I had been more worried about policy error a several weeks ago, does that mean that I'm getting complacent now? Hopefully, raising the question will remind me not to become complacent in the coming weeks.

And so begins another week. Will it bring more of the same?

If you've been following the debate over where the FOMC is heading and you want to know why it's so hard to know where the neutral rate is, you might want to read this short letter from the San Francisco Fed.

In other news, I'm not the only one who thinks that housing prices are not driving the Fed's agenda.

From Reuters:

ST LOUIS (Reuters) - The Federal Reserve will continue to raise interest rates amid strong U.S. growth and risks of higher inflation, with no hint that it is nearing a pause, Fed policy-makers made plain in comments on Wednesday.

"I think the inflation risks around the point estimate are skewed to the high side ... I would put a higher probability on an upside surprise," St Louis Federal Reserve President William Poole told reporters after delivering a speech to students.

"That calls for the Federal Reserve to make sure policy is risk-adverse with respect to that outlook," he said.

"We've been on a course of raising interest rates. The language in the last (Federal Open Market Committee) statement suggests that there was more to come...If we had wanted a different interpretation, we would have said something different," said Poole.

...

Markets bet this means three more consecutive quarter point rate hikes to 4.75 percent.

Unless anything drastic happens, I'd say that two more are a sure thing. The third is definitely a better than even chance. If forced to predict, I'd say yes. After that, I'm not ready to predict yet.

In the latest Econoblog at the Wall Street Journal Online, Tim Duy and I discuss what may be in store for monetary policy. We cover a range of topics from the Greenspan "conundrum" to the core vs. headline inflation debate. Here's a sample to whet your appetite. Early in the discussion, Tim remarks,

Still, even if Mr. Bernanke is immune from his critics' pressure, there remains a risk of policy error. As the federal-funds rate is pushed further into the 4% range, we will be closing in on the neutral point for monetary policy. A considerable amount of accommodation has been removed, and recent and expected rate hikes have yet to work their way into the economy. With the Fed seemingly locked on a higher rate trajectory, there will be a risk that past rate hikes will be slowing economic activity even as more tightening is implemented.

The Fed is cognizant of this risk and, I believe, will likely require a higher bar for rate hikes at some point early next year. The real trick for Mr. Bernanke might be the need to communicate the transition to a new policy direction at the same time the Fed is transitioning to new leadership.

For the rest of the discussion, go to the Econoblog page.

Some of my comments, and I think some of Tim's as well, were deliberately aimed at stimulating some blogosphere discussion. Consider this your invitation.

My appreciation goes out to the Wall Street Journal for running this feature. And of course many thanks to Tim Duy for his excellent comments and to Mark Thoma whose blog (Economist's View) is home to Tim's monetary policy commentary.

So says this NY Times article. It's a good read if you're just getting up to speed on the Bernanke nomination and the future of monetary policy. Go read the whole article. Here's a teaser...

"Inflation is clearly not right around the corner like it used to be," said Edward M. Gramlich, until recently a Fed governor and now interim provost at the University of Michigan. "The relationships are different, and Mr. Bernanke is going to have to figure them out."

Perhaps the biggest differences are the rise of global production, as well as much easier access to capital, particularly from abroad. Adding to the change is labor's weaker bargaining power. These factors have combined to greatly diminish the force of old-style inflation in which demand outran supply, pushing prices ever higher, and wages, too, until the Fed put the brakes on the economy.

Instead, a new style of inflation has emerged as one of the principal threats to the economy. It is evident in the stock market bubble of the late 1990's and in surging home prices in this decade. This asset price spiral, as it is called, has proved much more resistant to the Fed's standard interest rate tool than traditional inflation.

Mr. Bernanke, for his part, is known as an advocate of inflation targeting, a technique for adjusting interest rates with the aim of keeping traditional inflationary pressures within a limited range. He has also asserted, like Mr. Greenspan, that he does not intend to use interest rates prematurely to puncture an asset bubble. But he has signaled a readiness to use a different set of tools to fight the new inflation, and in this he departs from Mr. Greenspan.

Full statement here. Here are the important paragraphs:

Elevated energy prices and hurricane-related disruptions in economic activity have temporarily depressed output and employment. However, monetary policy accommodation, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity that will likely be augmented by planned rebuilding in the hurricane-affected areas. The cumulative rise in energy and other costs have the potential to add to inflation pressures; however, core inflation has been relatively low in recent months and longer-term inflation expectations remain contained.

The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.

The vote was unanimous and all 12 banks submitted requests to increase the discount rate.

The 2nd paragraph is the same as usual. The first has some different wording in light of the hurricanes and rebuilding. They mention the negative impact of the hurricanes but note that planned rebuilding (read, investment) will pickup in coming months. It's a very concise version of what we've been hearing for the last several weeks. One sentence contains the most interesting new word, as I see it,

The cumulative rise in energy and other costs have the potential to add to inflation pressures

"The cumulative rise..." sounds like an acknowledgement that what we have experienced so far is not a one-off event and not something that can be ignored. I am guessing that this word was very carefully chosen to give the right tone to the message. It's as if they are saying that now is not the right time to let our guard down. It does, after all, take time for these changes to work through the economy. If pressure is building now, it may be a few months before it affects the headline CPI in a big way. The heating season is ahead. The rate hikes are not over.

UPDATE: Mark Thoma (Economist's View) has more.

We'll see in 45 minutes or so. CNN has this story on their web site:

With Greenspan's term set to end on January 31, there is rising hope that the Fed may finally be prepared to remove the statement about how it plans to raise interest rates at "a pace that is likely to be measured."

"I'm hoping that Greenspan will see it in his wisdom to say, 'Okay, I'm going to put the brakes on and let the new Fed digest this economic data'," said Andrew Corn, chief executive officer Clear Asset Management, a New York-based institutional money management firm. "Changing the 'measured' sentence would have the right effect."

Corn argues that despite recent increases in the prices of oil and food, consumers have yet to get hit hard by price increases of other types of goods.

I'm thinking "measured" will stay in the statement today, 50-50 odds on the next one, and probably gone by January. Whether the rate hikes continue in after that or not, there will, I think, be a need for new language by that time.

What would it have taken in the last few weeks to cause the Fed to refrain from raising rates when it meets later today?

Ok, now come back to reality.

The meeting today isn't the big story anymore, either. The real story is what kind of chairman Ben Bernanke will be when (pending Senate confirmation) he takes office in 2006. And that's a whole lot more interesting than talking about foregone conclusions.

In fact, a week ago, the Bernanke nomination was all that anyone could seem to talk about. Though a new Supreme Court nominee has taken some of the spotlight off Bernanke for a while, do not despair. There's still a lot to talk about. All in good time.

The only question about today's meeting concerns the wording of the statement. "Measured pace"? Probably. Chalk it up to inertia. The phrase has been there so long that it will take compelling evidence that the rate hikes are about to pause. In the last few weeks, that evidence has dried up. Will there be a change in the risk assessment? That's a tough one. On the strength of the GDP report and given the inflation numbers, I think a stronger case can be made for tipping the risk assessment towards higher inflation. But I'm not sure the Fed really wants to put that out there at this point. I'd have to continue to expect the risk assessment to be balanced. Those two phrases are going to be among the first that people will look for, and I don't expect them to change.

Will the statement be slightly more hawkish, even if the risk assessment is the same? Probably either the same or more hawkish, but nothing drastic.

As always, I'll have my take on the statement itself as soon as it's on the Fed website. Tim Duy has an interesting take on the situation.

Beyond December, things get a bit fuzzier, in my opinion.

Read the rest. I'll add that as we get into to January, the question of whether the rate hikes are finished or not will depend on the incoming data. If we don't see some serious retreat on the inflation front, I don't see how Greenspan would leave without getting in one last shot. I'm inclined to predict rate hikes all the way to March. The difference between what I was expecting several months ago and what I expect now is that a few months ago I would have expected a pause by this time unless there was evidence in favor or more hikes. Today, a rate hike is the default position, and I have to see evidence to get me to think otherwise.

Beyond March, my view of the future is worse than "fuzzy"--it's like pea soup. But today is crystal clear. As always, I'll have some comments on the statement when it's up.

It's going to seem like a broken record pretty soon. When Brad DeLong sees things like this, he says, "Why, oh why...?" But it just doesn't stop. Enter James Grant with a NY Times op-ed.

But there is one rub. The man with the gray beard and the perfect résumé - winner of the South Carolina state spelling bee, Ph.D. from the Massachusetts Institute of Technology, former chairman of the Princeton economics department - professes to believe the impossible. He insists that the Fed can keep the economy chugging and prices stable just by pushing a single interest rate (the so-called federal funds rate) up and down.

...

Wall Street, of course, has other ideas. Thus the rally in stock prices following word of Mr. Bernanke's nomination was no vote of confidence that the presumptive chairman would settle on the right, or true, federal funds rate. It was, rather, an expression of hope that he would do his all to ensure a speculatively appropriate (meaning very, very low) rate.

Balderdash. Absolute nonsense. But he goes on...

Perhaps. But Mr. Bernanke's history shows he is not so much a believer in easy money as in the capacity of the Fed to take the right anticipatory action. Is the rate of inflation too high? Not high enough? With a twist of the monetary-policy dial, the problem is on its way to being solved. Let the Fed announce its target for inflation - say, 2 percent a year - and juggle its interest rate to cause that desired inflation rate to materialize. In so many words, the nominee contends, policymakers control events, rather than the other way around.

Here's a quote from one of Bernanke's speeches. You tell me if Mr. Grant is characterizing Bernanke's position accurately.

The person in the street might tell you that the Fed "controls interest rates." That statement is not literally accurate. In fact, the Fed has little or no direct influence over the interest rates that matter most for the economy, such as mortgage rates, corporate bond rates, or the rates on Treasury securities. Instead, the Fed affects these key rates, as well as the prices of financial assets such as stocks, only indirectly.

For a speech to an audience of nonspecialists, that's pretty clear. There are nuances, of course. And the fact that Bernanke's research focuses so heavily on the transmission mechanism is in a way an admission that there is a lot we don't know about the indirect part. That's hardly a characteristic of someone who thinks we can simply "twist the monetary policy dial" and solve the problem.

Mark Thoma (Economist's View) links to a paper by Bernanke and Blinder in this post. The paper is about the credit channel for monetary policy, a topic that Bernanke would revisit a few more times, including this paper (joint with Mark Gertler) in the Journal of Economic Persectives titled "Inside the Black Box: The Credit Channel of Monetary Policy Transmission" (JSTOR link--subscription required).

Also important is this paper in the American Economic Review titled "Agency Costs, Net Worth, and Business Fluctuations." Quoting from the introduction:

First, since borrower net worth is likely to be procyclical..., there will be a decline in agency costs in booms and a rise in recessions. We will show that this is sufficient to introduce investment fluctuations and cyclical persistence into an environment which is rigged to exhibit neither of these features when agency costs are not present; a kind of accelerator effect emerges. Second, shocks to borrower net worth which occur independently of aggregate output will be an intitiating source of real fluctuations. A possible example of this is "debt-deflation," first analyzed by Irving Fisher (1933): During a debt-deflation, because of an unanticipated fall in the price level (or, alternatively, a fall in the relative price of borrowers' collateral, for example, farmland), there is a decline in borrower net worth. This has the effect of making those individuals in the economy with the most direct access to investment projects suddenly un-creditworthy.... The resulting fall in investment has negative effects on both aggregate demand and aggregate supply.

At the root of the problem is the information asymmetry between the borrowers and lenders which gives rise to agency costs. Bernanke and Gertler find that this specific friction can have balance sheet implications which give rise to real fluctuations. It is another example of the credit channel, but a very specific one. It highlights one of the reasons that deflation (or a fall in the value of collateral) is such an important problem. Deflation has balance sheet implications, and with information frictions (agency costs), there is a real effect on output. This kind of research linking the financial and the real sector is present in much of Bernanke's work.

If we are to make progress on the current puzzles confronting policymakers, a good framework for thinking about the linkage between the real sector and the financial sector is vital. One of the Fed's most important roles is as lender of last resort. The are a provider of liquidity in time of crisis, whether that crisis takes the form of a terrorist attack across the street or a currency collapse across the globe. Understanding seemingly esoteric subjects like the transmission mechanism has important implications for the way the Fed thinks about the real consequences of balance sheet problems.

With all the attention on Ben Bernanke today, I looked back at some of my past posts. Here's one from April.

This excellent speech by Ben Bernanke should be read by every macroeconomics student. I think it is good that Fed governors actually get out there in the public and make speeches like this once in a while.

Here's a sample.

The person in the street might tell you that the Fed "controls interest rates." That statement is not literally accurate. In fact, the Fed has little or no direct influence over the interest rates that matter most for the economy, such as mortgage rates, corporate bond rates, or the rates on Treasury securities. Instead, the Fed affects these key rates, as well as the prices of financial assets such as stocks, only indirectly.

I like that speech more every time I read it. It fits perfectly with the way I teach macroeconomics. The truth is that when Bernanke was appointed to the Board of Governors the first time I was really pleased. I had heard his name bandied about for a while as a potential governor. I think most dedicated Fed watchers had him on their short list back then. Once he joined the Board, his speeches were some of the most refreshing, at least to an academic economist. They were perhaps too refreshing--too open and honest--to be appropriate for a Fed chair. But, and this is important to remember, he wasn't the chair (or even the nominee) back then. Academic candor isn't always what the financial press wants. One sentence in one speech, and he is forever known to some as "Helicopter Ben." That is unfortunate, because that is not an accurate assessment of the totality of his writing (or even of that speech). But then, how many of us remember anything else from the speech where Greenspan said "irrational exuberance"?

Remember that Bernanke will be forging a consensus of the whole FOMC. That group includes some pretty dedicated inflation hawks right now, but it also includes some that will be reluctant to embrace explicit inflation targeting. He will also have to be the public face of the Fed in front of members of the House Banking Committee like Representatives Ron Paul, Bernie Sanders, and Maxine Waters, who will be sure to remind Bernanke at every opportunity that the Fed still does officially have a dual mandate.

When Ron Paul or Bernie Sanders would chastise Greenspan up on the Hill, the Chairman would just sit their with that trademark look on his face, waiting for an actual question that he could answer (or not). That's a skill that Bernanke will have to learn. Academic lectures won't work on the Hill. Pity. But it's true. Academic lectures explore the issue from many sides. We academics like to play "what if?" games. Fed chairmen must be more circumspect about what economic indicators play into interest rate decisions and related matters.

I'm pleased with the nomination of Bernanke because he is a good economist. It's too bad that in order to fit the central banker mold he'll now have to largely abandon the open, questioning, analytical, academic persona that my profession has been praising today. In many ways, he seemed more suited to the job of governor than chair because a governor can afford to be a little more (but only a little more) open. However, if he causes us to have a real debate about the value of inflation targeting, rules vs. discretion, and whether there really is a "global savings glut," I think it will be a positive step in the history of the Fed. At the end of this very exciting day for Fed watchers, I find myself looking forward to these debates on the horizon. He's an excellent choice to lead the Fed at this critical time.

I tip my hat to David Altig for alerting us to this Bloomberg article. (While you're there, read Altig's post on core vs headline inflation!)

The new chairman ``needs to commit themselves very firmly to the Fed's commitment to price stability in deed as well as word,'' said J. Alfred Broaddus Jr., former president of the Richmond Federal Reserve Bank.

...

Bernanke is an advocate of a strategy called inflation targeting where a central bank specifies a numerical goal for prices. The Federal Open Market Committee debated the strategy as early as February, and decided to defer the discussion.

Bernanke is unlikely to push the strategy unless he has unanimity, and Governors Roger Ferguson Jr. and Donald Kohn are opposed. Both may be willing to discuss a numerical description of what defines low inflation, and that could help solidify the Fed's inflation-fighting credibility with financial markets, households and businesses.

``Certainly, an inflation target that is explicit is one more step toward greater transparency,'' Broaddus said.

Since he was sworn in at the CEA on June 21, Bernanke has testified twice before Congress and given five speeches on non- controversial subjects. As a Fed chairman, his second test will be gaining credibility on Capitol Hill.

...

The Fed is unusual among the world's central banks in that it has two mandates: stable prices as well as sustained growth that will result in low unemployment. Bernanke will have to at least express concern about jobs and growth in his nomination hearing, and, if confirmed, during his semi-annual testimony in February.

Delivering on the expansion will be tricky, however.

Economists expect U.S. growth to slow, even as inflation expectations rise in the aftermath of a 51 percent increase in retail gasoline prices this year. Fed officials have made it clear they intend to keep leaning against inflation by pushing up the federal funds rate, even after Hurricanes Katrina and Rita hurt third-quarter growth prospects.

St. Louis Fed Bank President William Poole even said that the Fed could err on the side of raising interest rates too high to clamp down on inflation because it could them cut them quickly if growth began to falter.

And in this post, Brad Setser lays out the problems with the "global savings glut" hypothesis as well as the parts he thinks Bernanke got right. In my comment on "Econoblog", I mentioned that this would be a subject for discussion.

Nouriel Roubini has some thoughts at his blog as well.

UPDATE: King at SCSU Scholars has a nice post which begins:

Should we make any big deal of the fact that the bond market sold off today, with Ben Bernanke replacing Alan Greenspan at the Fed? No, because looking at the inflation-indexed bond market shows that both indexed and non-indexed bonds fell by roughly the same amount. Were the concern about Bernanke that he would be softer on inflation, the non-indexed bond should have fallen more than the indexed bond. That link also includes a reminder that the bond market sold off when Alan Greenspan replaced Paul Volcker in 1987.

...

Everyone wants things to stay as they are with monetary policy, and the market prices uncertainty by asking for a higher real yield. Thus today's bond market.

Go read the whole thing.

A number of economist bloggers were asked by the Wall Street Journal for comment on the Bernanke selection.

You can read all of our comments at the WSJ Econoblog page.

NY Times story here.

More to follow.

UPDATE: Greg Ip writes a very nice article in the Wall St. Journal with many links in the sidebar. (subscribers only) The quote I wish to highlight comes from across the Atlantic.

In Europe, Jean-Claude Trichet, President of the European Central Bank, was quick to praise Mr. Bush's choice. "Ben Bernanke is a highly respected central banker, a remarkable economist and a man of experience. I will be very happy to have the possibility to develop with him the same highly close and fruitful cooperation, and enjoy the same confident and friendly personal relationship that I had with Alan Greenspan."

And, now that you've read the quick comments posted on Econoblog, it's time to see the longer versions coming out in the blogosphere. After all, people have been holding all of this in a long time.

Larry Kudlow posts on his blog and at The Corner (NRO):

Thank heavens that Fed board member Donald Kohn, who is a demand-sider and a Phillips Curver, did not get the nod.

This prompts Brad DeLong to tear his hair.

But Ben Bernanke is a demand-sider and a Phillips Curver. Here's a representative speech:

FRB: Speech, Bernanke--An unwelcome fall in inflation?--July 23, 2003: Much of the analytic framework used by the [Federal Reserve] staff and other leading forecasters can be summarized by an expectations-augmented Phillips curve, of the type implied by the work of [Milton] Friedman (1968) and [Ned] Phelps (1969), further augmented by measures of "supply shocks," as suggested for example by the work of Robert Gordon (for a recent application, see Gordon, 1998). This model is familiar from many textbook treatments. In addition, most variants of the model include dynamic elements, in order to capture aspects of expectations formation, multi-year contracts, and other factors.... If aggregate demand is below potential output, implying a positive output gap, the rate of increase in labor compensation and other input costs should slow, firms should be less able to pass price increases, and thus inflation should slow....

DeLong quotes even more of the speech, but you get the idea. For the record, DeLong is happy with the choice

Tyler Cowen runs down a list of Bernanke's major contributions to economics. Can't say I disagree. I was just starting grad school about the time that his paper on the Great Depression came out. As a first year grad student, I hadn't been introduced to some of his previous work yet, so this is the first thing I remembered him for. Of course I followed his work as he started to write about inflation targeting as well.

Over at the Volokh Conspiracy, Juan "Non-Volokh" writes,

If Cowen and DeLong agree — and the markets are up — who am I to suggest otherwise. (After all, I'm just a law professor.)

The New Economist has a great opening line:

After a serious of dubious political appointments it seems common sense has finally prevailed at the White House when it really matters...

Mark Thoma is pleased. He links to Bernanke's homepage. He closes his post with these thoughts:

Who will oppose Bernanke? The strongest statement against him is this tirade by John Tamny from the NRO. As noted in the write-up on Tamny's statement and by Brad Delong, Tamny's arguments have little validity. The piece seems to have been motivated by Bernanke's refusal to drop solvency as part of Social Security reform.

The speculation isn't over as this brings up more questions. Who will be the next chair of the CEA? Who will fill the other open seat on the Federal Reserve Board of Governors?

Well, I think that Bernanke will face some questions about his "helicopter drop" speech. (The speech was about the possibility of deflation.) Now hear me well: I didn't find anything objectionable in the speech, but some financial reporters didn't understand the context. I mention this only because I think I heard this come up in Scott McClellan's White House press briefing today before the announcement (I'll check the transcript when it's up). He will also have to answer some questions regarding the "global savings glut" (I mentioned this in the Econoblog comment).

As more is written, and as he answers those questions, I'm sure there will be more to talk about. The bottom line is that I'm very happy with the choice. I expect Ben Bernanke to be a good communicator of the policy of the Fed (even though he will need to learn how to obfuscate a little bit). He's got his ear to the ground regarding the latest economic research. And he doesn't wear his politics on his sleeve. All of these are good traits to have in a Fed chair.

I expect more discussion in days ahead, but I'll stop here for now.

UPDATE 2: James Hamilton sums it up nicely:

He absolutely has a first-rate mind, just as sharp as they come. And he'll need all the gray matter that can be mustered in his new job, I fear, to figure out how to respond to simultaneous threats of recession, inflation, global imbalances, and systemic financial risk.

I've disagreed with Bernanke on a number of specific issues over the years. Some of those arguments I admit that he won, and some I still view as unresolved. I certainly reserve the pundit's prerogative to start criticizing whatever he does with monetary policy the day he takes charge, nay, even before he assumes the office, I shall feel free to kvetch. But I will be doing so from a position of respect for the new office holder.

Read the entire speech on the Cleveland Fed website. Here is the part people will be talking about.

The important thing to recognize is that, unless energy prices continue to grow at the rate we saw this summer — something I consider very unlikely — their effects on the overall rate of inflation should prove to be temporary. The inflation statistics we see in the near term may look discouraging. However, most professional forecasters — the Blue Chip forecasters, the Congressional Budget Office, and others — share my expectation that inflation should moderate substantially next year.

Looking forward into 2006, the most probable course for the economy after the hurricanes is very close to the course that seemed likely before the hurricanes. We are likely to have a moderately expanding economy, in which the headline inflation numbers gradually slow down and move into line with the much-lower core inflation rate.

Likely, that is, if monetary policy does its part to keep those temporary pressures from translating into more persistent inflation. Temporary inflation will turn into longer-term inflation only if the FOMC allows expectations of persistent inflation to build. The key question is what course monetary policy should take to keep inflationary expectations from taking hold.

That brings me to my outlook for monetary policy. I have come to think of monetary policy as a plan — a plan that contemplates the many paths that the economy might take, and that formulates an appropriate response in anticipation of those possibilities.

...

We have continued with that plan of removing policy accommodation over the past year-and-a-quarter, as we have adjusted the federal funds rate target from 1 percent to 3.75 percent. As I said, Katrina and Rita did not change the broad contours of my forecast for continued economic growth and lower inflation into 2006. So, to me, the plan of continuing to remove the remaining amount of policy accommodation still looks like a sound one.

We have already removed a substantial amount of that accommodation, and it is fair to ask how much further we might have to go. Although the hurricanes did not change my best estimate of future economic activity, they did — as our last FOMC minutes indicate — increase the degree of uncertainty surrounding that estimate. The answer to how much higher the federal funds rate needs to go depends on how economic conditions unfold. So, let me share my thinking about a couple of possibilities that I have been contemplating.

First, it is possible that consumers will retrench their spending by a greater degree, and for a longer period of time, than we expect. Households have yet to experience the full impact of the recent energy-price increases, especially in the form of higher home-heating bills this winter. The long run-up in energy prices could finally prove to weigh heavily on consumers and significantly reduce their spending on non-energy items. In that case, the economy could become fragile and further increases in core inflation could prove to be even less of a worry than today. If consumer spending and inflation pressures appear to be weakening across the country, then the appropriate federal funds rate might prove to be lower than it would be otherwise.

Alternatively, total spending could bounce back more strongly than I anticipate — while at the same time consumers, businesses, and financial markets react to sustained increases in energy prices by raising their longer-term inflation expectations. In this case, a higher federal funds rate may be required, so that monetary policy does not unintentionally support an inflationary environment - one in which prices for a broad range of goods and services steadily rise.

Monetary policymaking requires managing risks. That means having a plan that is flexible enough to take into account sudden surprises and changing conditions. While I may be uncertain about which path the economy will take, I am clear about the goals of the central bank. I believe being prepared means, first and foremost, being in a position to respond if threats to price stability arise. Removing the remaining monetary policy accommodation puts us in the strongest possible position to react as evolving economic conditions require.

Like economists are so fond of saying, "It depends." Kash's post today falls into the same category. Will consumers cut back on non-energy purchases when heating costs go up this winter? Will the labor market be strong enough in that environment for people to ask for wage increases? The ultimate level at which the funds rate will reach in this tightening cycle depends on those and other factors.

UPDATE: The Beige Book is up at the Fed's website.

UPDATE: Reuters summarizes the day's speeches.

Links to speeches by Donald Kohn and Richard Fisher.

Michael Mandel alerts us to this article in BusinessWeek by Rich Miller. Here's an interesting passage.

In past crises, Greenspan was able to act independently, backed up by the most powerful central bank in the world. For example, in 1998 the Fed moved quickly to avert a disaster after Russia's debt default and the near-collapse of giant hedge fund Long-Term Capital Management threatened to bring global financial markets to a standstill. "We were acting as central bank for the world," says Alice M. Rivlin, who was Fed vice-chair at the time and is now at the Brookings Institution.

That's no longer possible. A crash landing of the dollar could trigger a financial meltdown and put the Fed in a quandary: It could flood the banking system with dollars to buoy the financial markets. But that would then run the risk of triggering an even faster fall of the dollar and a sharp spike in long-term interest rates as foreigners dumped their U.S. bonds.

In that scenario, the U.S. could not act as global lender of last resort, as it did in 1998, says Karin Lissakers, a former U.S. director at the IMF, in a paper presented at a recent Institute for International Economics conference. Nor is there any other institution that could easily step into the role. The IMF is an obvious candidate. But its decision-making apparatus is cumbersome and its finances limited for handling a mega-crisis like a dollar crash. The Bank for International Settlements in Basel, Switzerland, sometimes called a club for central bankers, could serve as a forum for collective action. But it has no finances of its own to contribute.

In the end, what would likely happen is that a small group of central banks, including the Fed, would band together to prop up the global financial system. That approach puts a premium on having a Fed chairman who can collaborate effectively with overseas counterparts to defuse the crisis. The chief would also have to work closely with the Treasury Dept., while being independent enough to reassure skittish foreign investors.

CNN.com weighs in with this piece.

Usually the market's reaction to a new Fed chief was short-term, with the more surprising the person, the bigger the market's move.

Stocks and the dollar both rose in the first few sessions after Paul Volcker's appointment in 1979, as he was seen as picked to cool inflation, said Ken Kuttner, Danforth-Lewis Professor of Economics at Oberlin College.

Investors were less sanguine about G. William Miller in 1978. Stocks slipped and the dollar sank 2.4 percent in the first three days after he was named, Kuttner said.

After Volcker's resignation and Greenspan's appointment in 1987, stocks hiccuped, the dollar fell and bond yields rose, but then recovered pretty quickly, Kuttner said. "Greenspan was something of an unknown quantity at the time, while Volcker had built up very strong anti-inflation credentials over the years."

In each of those cases, the turnover was something of a surprise, Kuttner said, noting that in 1978, Arthur F. Burns was eligible to serve another term, but President Carter opted not to reappoint him, instead appointing Miller.

Not warmly received by anyone, Miller was yanked after less than a year-and-a-half and sent to the Treasury, and Volcker's resignation was a surprise.

"By contrast, everyone knows Greenspan is leaving in January," Kuttner added.

Another contrast is the economic environment itself. "In the 1970s we were in an environment that no Fed chair had been through in a modern economy," Naroff added, referring to soft growth and soaring inflation.

In the BusinessWeek piece, some new names are mentioned. Both pieces broach the subject of an unexpected pick. I'm just sayin'...

Primarily inflation expectations and long term growth prospects.

Federal Reserve policy actions affect the long rate indirectly through inflation expectations. Using the (short term) fed funds rate to try to affect long term rates would be ill-advised. So says Fed Governor Mark Olson: (Reuters)

SEATTLE (Reuters) - Federal Reserve Board Governor Mark Olson said on Thursday it would neither be appropriate nor effective for the U.S. central bank to use official interest rates to try and influence longer-term borrowing costs.

After a speech at Seattle University that largely echoed one in Vancouver on Wednesday, Olson said during questioning from panelists and audience members that he thought financial markets were increasingly looking at whether risk was being priced correctly.

"We would not try to use monetary policy to fix or to determine the shape of the yield curve. That would not be appropriate, nor could that be conducted I think," Olson said.

On the same topic, Dave Altig (macroblog) had this to say today.

Higher short-term interest rates may indeed be the response required to keep inflationary pressures in check. But that, in the long-run, will mainly impact the inflation premia required of borrowers by lenders. It is certainly possible that an overly restrictive will temporarily drive up real interest rates. But that strikes me as policy mistake, not a prescription.

Greenspan found the lack of movement at the long end of the yield curve to be a "conundrum". That lack of movement in long term rates undoubtedly contributed to the housing boom (bubble, if you prefer). It has fueled a lot of consumer spending and increased debt. All that is true. But the main policy tool of the Fed just isn't set up to fine tune long rates.

Conducting monetary policy in a low, stable inflation environment is not without its own set of difficulties. But consider the alternative--when policymakers are forced to raise the short term real rate to bring down inflation expectations (and therefore the long term real rate). This chart will jog your memory. Expectations do not turn on a dime.

I'll take the current set of difficulties anytime.

It's that time again. Click here for the minutes.

This is a long post due to the fact that these minutes have some potentially important implications, and because of that I am quoting large segments. This will be food for thought for a while, so do read them carefully.

Some choice segments:

The Committee's decision at its August meeting was widely expected in financial markets and evoked little price reaction. Over the intermeeting period, however, investors marked down their expectations for the path of policy, partly in response to the devastation caused by Hurricane Katrina. Nominal Treasury yields decreased about in line with the revision to policy expectations. Yields on inflation-indexed Treasury securities fell a bit more than their nominal counterparts, leaving inflation compensation slightly higher. Spreads on investment-grade corporate bonds were little changed over the intermeeting period, but those on speculative-grade bonds increased from very low levels. Major equity indexes appeared to be supported by lower interest rates and posted modest gains despite the increases in energy prices. The trade-weighted foreign exchange value of the dollar depreciated slightly over the intermeeting period.

...

In the forecast prepared for this meeting, the staff lowered its projection for economic growth over the remainder of 2005 in light of the economic dislocation associated with Hurricane Katrina. At the same time, however, the staff increased the growth rate forecast for 2006 to reflect the boost to economic activity from the rebuilding effort. By 2007, the level of output was expected to move back to the path it would have followed in the absence of the storm. The staff revised upward its forecast of overall inflation for 2005 and of core inflation for 2006, reflecting the effects of higher energy prices, but lowered its projection for overall inflation slightly for 2006. It was recognized that there were considerable near-term uncertainties and that many data series in coming months would be influenced by the effects of the storm.

Emphasis mine. Reference my comments here and here. In the former, I remark,

Is there any reasonable scenario in which real GDP in 2007 ends up higher than it would have been without the hurricanes?

The Fed appears to understand that broken windows can alter the timing of spending, but have little effect on potential GDP.

It was also interesting that they revised their forecast for overall inflation downward for 2006 but core inflation upward. (I can't wait for Barry Ritholtz's take on this.) Moving on in the minutes:

...On balance, participants thought that there would likely be a significant shift in the timing of aggregate economic activity over the next several quarters but probably little effect on the economy's intermediate-term growth prospects. Several participants voiced concern that the effects of the hurricane were likely to add to already considerable pressures on prices.

The investment picture is cloudy as well...

Meeting participants noted that, even prior to the hurricane, business fixed investment had been somewhat weaker than expected. The softness was somewhat puzzling, as sales were growing, business balance sheets appeared quite strong in the aggregate, profitability was high, and financing was readily available and relatively inexpensive for most firms. Although the apparent sluggishness could reflect only short-term fluctuations in volatile data series, some evidence suggested that it may also have stemmed from concern among business executives about the effects of high energy prices. The anecdotal information on commercial real estate markets was mixed, with some districts reporting firming markets while activity elsewhere was said to remain subpar.

And you knew this was coming...

With regard to fiscal policy, meeting participants noted that federal outlays would increase sharply in order to assist with recovery and reconstruction efforts in the aftermath of the hurricane. The eventual size of the increment to federal outlays was unclear, but it was likely to be quite large. The substantial step-up in government spending would add to federal deficits that were already large and underscored the worrisome loss of fiscal discipline evident in recent years. The expansion of federal spending implied an increase in fiscal stimulus at a time when the margin of unutilized resources in the overall economy was probably thin.

Slack? What slack?

Oh, and I think that's the first time I've seen the words "loss of fiscal discipline" in the minutes like that.

In this next section, try to guess which participants it refers to...

Participants' concerns about inflation prospects generally had increased over the intermeeting period. The surge in energy prices, in particular, was boosting overall inflation, and some of that increase would probably pass through for a time into core prices. This posed the risk that there could be a more persistent influence on inflation should inflation expectations rise. Indeed, some recent survey evidence on such expectations had been troubling, and widening federal deficits were mentioned as a factor that could further stir inflationary concerns. Measures of labor costs were giving conflicting signals, with some indexes indicating that growth in labor compensation remained relatively low but another showing appreciably more rapid increases. Anecdotal information continued to point to shortages of certain types of labor, such as truck drivers, and some business contacts reported difficulties in hiring more generally, a development that had prompted some firms to boost wages. Underlying productivity growth to date apparently had remained robust but, at this stage of the business cycle, gains in productivity could not necessarily be counted on to stay strong. The prices of a number of intermediate goods, including a wide range of petrochemical products and building materials, were subject to upward pressure, reflecting high crude oil prices, production disruptions in the energy sector, and elevated demands for materials in anticipation of rebuilding in the Gulf Coast region....

On the other hand...

...Still, core inflation in recent months had been quite damped, and market-based measures of longer-term inflation expectations had risen only modestly of late. It was observed that, after the early 1980s, the pass-through of energy prices into core inflation had been quite limited, suggesting that, in current circumstances, core inflation could stay relatively low and overall inflation would probably drop back if inflation expectations remained contained.

Oh, and about that pause...

In the Committee's discussion of monetary policy for the intermeeting period, nearly all members favored raising the target federal funds rate 25 basis points to 3-3/4 percent at this meeting. Although uncertainty had increased, in the Committee's judgment the fundamental factors influencing the longer-term path of the economy probably had not been affected by the hurricane, but the upside risks to inflation appeared to have increased. Even after today's action, the federal funds rate would likely be below the level that would be necessary to contain inflationary pressures, and further rate increases probably would be required. Moreover, the uncertainties about near-term economic prospects resulting from Hurricane Katrina would probably not be reduced materially in coming weeks. Indeed, underlying economic trends would be particularly difficult to assess over the next several months as a result of the direct, and presumably temporary, effects of the storm and its aftermath on the incoming data. A pause in policy tightening at this meeting had the potential to mislead the public both about the Committee's perceptions of the fundamental strength and resilience of the economy and about its commitment to fostering price stability.

Yes. I agree that a pause at that point would have been misleading. But what about the future?

...The Committee also agreed to reiterate its previous expectation that ". . . policy accommodation can be removed at a pace that is likely to be measured." However, some sentiment was expressed to consider changes to forward-looking aspects of the statement at upcoming meetings, in part because of the considerable reduction in monetary policy accommodation that had already been accomplished.

When I read that, I get the picture that "measured pace" really has come to mean 1/4 point until further notice. So it doesn't leave much doubt as to the next meeting's outcome. But "changes to forward-looking aspects of the statement" might be a signal to watch for the next statement and certainly the one after that for some new language. And to admit that a "considerable reduction in monetary policy accommodation" has "already been accomplished" seems to be a sign that as we move into 2006 we may not see increases at every meeting.

I guess you could say the second derivative might be about to turn negative, even if the first is still positive.

Finally,

Mr. Olson dissented because he preferred that the Committee defer policy action at this meeting, pending the receipt of additional information on the economic effects resulting from the severe shock of Hurricane Katrina.

Plenty to talk about.

One of the more (visibly) hawkish members of the FOMC is fast becoming one of the most often quoted.

Reuters:

"Readings on core inflation have been within the acceptable range of 1 to 2 percent, but they are edging closer to the upper end of the Fed's tolerance zone," [Fisher] said during a speech in Waco, Texas, on Thursday.

"Fisher's comments definitely caused increased concerns about inflation and future rate hikes, and I think the comments were about the most hawkish comments from a Fed (official) during this inflation cycle," said Chris Burba, market analyst at Standard & Poor's. "The Fed may be trying to brace the financial markets for more rate hikes."

UPDATE: Frequent commenter spencer opines that he's not seeing the inflation. He would probably nod his head in agreement with this NY Times article.

The editorial pretty much speaks for itself.

Hopes die hard, so we strongly encourage Mr. Bush to put his money where his mouth is this time around. This job is too important for another taste of cronyism.

The person to be the next chair of the Fed, that is.

Reuters:

WASHINGTON (Reuters) - U.S. President George W. Bush said on Tuesday he has not yet been given a list of prospective names for new chairman of the U.S. Federal Reserve, but expects to name a replacement for Alan Greenspan "at an appropriate time."

"There is a group of people inside the White House who will bring forth nominees," Bush told a news conference in response to a question. "It's important that whomever I pick is viewed as independent from politics."

"I personally haven't seen any names yet," Bush said. "I'll name the person at an appropriate time."

Bush said that while the group inside the White House aimed to "surface some names internally" it also wanted to "reach outside the White House and solicit opinions" about who the next head of the U.S. central bank should be.

The speculation, of course, has been going on for quite some time. It might have been nice to have a nominee in the summer, but I can also understand why the White House would want to wait. It's been a long time since we've done this, but Greenspan was appointed, confirmed, and took office in a span of just a couple months when Volker resigned.

It would be difficult (though perhaps not impossible) to nominate and confirm someone all in the month of January. You ultimately would have to weigh which alternative is worse--letting the market spend the holidays in suspense or giving the pundits a month to speculate on what the nominee will do upon taking office. Good and bad to both, I guess.

I don't think they would want to nominate someone before the end of the year and have the nomination hanging into the new year. Given that Congress will probably want to adjourn in November (though they have not set a date yet), one would think that a nominee could come this month--if they want it done by the end of the session.

Technically, the next term begins on February 1, so that person should be named (and confirmed) by the end of January. The first meeting of the year is January 31 and February 1--the precise timing of the start of a new term for Greenspan's seat on the board. (UPDATE: See below) If a new chair has not been confirmed, my understanding is that Greenspan would continue as chair until that time. If that's the case, a January nomination with an February confirmation would let Greenspan finish out that two day meeting in his capacity as chair and provide a rather sensible transition.

Is that what Bush means by "an appropriate time"?

Your thoughts are welcome. We're all just speculating here.

In other Fed news, FOMC members Fisher and Poole both made comments on inflation today. Fisher was decidedly hawkish, much like he was in his last speech. Poole's remarks were that the Fed would respond to "surprises in core inflation."

Full speech by Richard Fisher

Full speech by William Poole

UPDATE: Calculated Risk informs us that the meeting in January has been shortened. I found the press release about it. The schedule on this page still mentions a two day meeting. Perhaps they will correct that. In any case, your guess is as good as mine as to when the "appropriate time" will be.

From Reuters

Fed Chair Alan Greenspan remarks,

"Because it is difficult to suppress growing market exuberance when the economic environment is perceived as more stable, a highly flexible system needs to be in place to rebalance an economy in which psychology and asset prices could change rapidly," he said.

Prices for both U.S. stocks and government bonds rose a bit after his remarks as traders showed relief he had not signaled higher-than-expected interest rates ahead.

The fact that he did not use the word "irrational" probably helped too.

The whole speech can be read at the Fed's web site.

I found these while checking the Chicago Fed website for Michael Moskow's speech.

Bill Testa is blogging on the Midwest economy for the Chicago Fed. He is vice president and director of regional programs in their research department. His latest post is on ethanol.

Tim Schilling is a former high school teacher in charge of the economic education efforts at the Chicago Fed. He is blogging on issues related to economic education.

The home page of the Chicago Fed blogs can be found here.

Both are welcome additions to the economics corner of the blogosphere. Check them out!

In my last post, I asked some questions that have been occupying my mind lately. Keep the comments coming.

Here's an interesting remark from Jacob at Everyone's Illusion, a relatively new blog worth adding to your blogroll.

The danger in pausing is the Fed may be running out of time. The Fed is worried about monetizing the ever growing deficit as well as oil price increases. Oil price (really gas price) inflation makes politicians do odd things, most of which are inflationary. The temptation is for more subsidies, increased payments for exploration companies, cash handouts to alternative sources, in other words more government spending.

Normally the risk of a pause would probably be minimal as it is the cumulative effect of Fed increases that matter, not any particular 25bps. Furthermore, they could always raise 50bps if things were looking like they were getting out of hand. This time there is one major difference; Greenspan is leaving.

...

The Bush administration clearly values loyalty in its appointments. The new Chairman will likely start at a time where the risks of a slow down and inflation are quite high. The Republicans are facing an election in 2006 where they certainly do not need a “fed caused” recession when voters go to the polls. If you don’t think these issues will come up when Bush interviews candidates I think you are being naive.

Greenspan knows the successor will have less cover then he does. There are only 3 more meetings until he retires which brings the rate to 4.50%. If they pause once, the max Greenspan rate is 4.25%, twice and its 4.0%. Even if the Fed thinks 4.25% is enough (or even 4%) they run the risk of the new Chairman being forced into pausing for a few meetings and things getting out of hand. Better to raise too much (possibly) and let the new Chairman gain political favor by being the one who pauses or cuts to starve off recession.

It's an interesting hypothesis, that Greenspan might want to give the new Chairman the ability to pause at some point early in his tenure. It's certainly possible. The one slight problem with it is that while Bush may value loyalty, the job of Fed chair is not the same as a cabinet post. The Fed chair (indeed, any Fed governor) does not serve at the pleasure of the president. He can be removed for cause, but not because of policy disagreements. And furthermore, whoever is picked will be subject to reappointment as chair not by Bush, but by the next president. So I'm not convinced that a pause would logically come after the new chair is in office--especially if the new chair comes in with a reputation as an inflation hawk.

But this much is certainly true. The tension between the Fed and Congress over the deficit is building by the day. That will be the new chair's biggest challenge. If the new chair pauses the rate hikes right away, I'd be worried that market expectations of inflation could come unglued. In the best of all worlds, I'd have Greenspan pause the rate hikes and have an avowed inflation fighter resume them.

I guess we'll see how it plays out. Of course, we still don't have a replacement for Greenspan. So I'll toss out this hypothesis... there will not be a pause until we know who Greenspan's replacement is.

Discuss.

In other Fed news, Michael Moskow says that it is still "necessary to reduce accommodation." He also discusses "flexible inflation targeting" in his speech.

Is the Fed risking recession? In James Hamilton's most recent post, he seems to think so. Tim Duy suggests that the Fed is sending a clear message that it will target price stability rather than full employment growth if forced into an either/or choice. I will simply add that managing expectations will matter a lot here. A little bit of aggressiveness against inflation now will help contain inflationary expectations and prevent an incipient downturn from turning into full blown stagflation. In fact, the Fed's management of expectations, while it hasn't been perfect, has probably already kept inflation expectations fairly (well) contained. (Include the word "well" or not, as you like.) That said, it would not be inappropriate to allow the economy to take a breath sometime in the next few months as long as expectations remain in check. But I'm aware that a pause in the rate hikes is not without it's own set of problems.

I'll throw out these questions to the blogosphere: What are the dangers of a pause in the rate hikes? What are the chances that the market would misinterpret it and see it as a signal that the Fed is done raising rates or that they see recession on the horizon? If you were on the FOMC, what would you do between now and the end of the year to minimize that risk? Do you think that these risks would cause the Fed not to want to pause at all, but treat "measured pace" as meaning 25 b.p. per meeting until they feel they're at the neutral funds rate? Would that be good policy?

Yes, those are tough questions. That's why I'm not answering them all here tonight. It is late as I write this, but these questions will be with us for many weeks. I'll come back to them from time to time with my thoughts.

Have at it.

Today's FOMC statement was clearly a bit on the hawkish side. Let the blogtalk commence on what it means. I'll start with this.

What is a neutral fed funds rate, and how soon should we try to get there? This is pretty much equivalent to asking, when and at what rate to the hikes finally stop. A year ago, I said 3 to 4% in the next 12 to 18 months. We're there and not stopping. More recently I've been thinking 4 1/2% next spring. Now, 5% by summer is a real possibility, and if someone gave me even money on an over/under bet, I'd have to give serious consideration to "over".

They seem very comfortable with 25 b.p. at a time. The fact that they are not changing the measured pace language makes me confident that 50 b.p. moves are out of the question unless core inflation really makes a move. So to be "hawkish" right now seems to mean extending the time horizon for the increases rather than squeezing tighter and faster.

I suspect that many in the market, and many of you, probably have the same assessment. Does this mean that they are doing a pretty good job of managing expectations? Are expectations about the length of time the rate hikes will continue easier to manage than expectations about how big the steps will be or when there will be a pause? Is there anything, short of a drop in GDP, that would induce a pause before year's end?

My answers are yes, maybe, and I'm beginning to wonder. Comments are open.

Let's dig in. Full FOMC statement here. First, there is a paragraph and a sentence about Katrina.

Output appeared poised to continue growing at a good pace before the tragic toll of Hurricane Katrina. The widespread devastation in the Gulf region, the associated dislocation of economic activity, and the boost to energy prices imply that spending, production, and employment will be set back in the near term. In addition to elevating premiums for some energy products, the disruption to the production and refining infrastructure may add to energy price volatility.

While these unfortunate developments have increased uncertainty about near-term economic performance, it is the Committee's view that they do not pose a more persistent threat.

This is consistent with what we've been hearing. Then we have the outlook.

Rather, monetary policy accommodation, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Higher energy and other costs have the potential to add to inflation pressures. However, core inflation has been relatively low in recent months and longer-term inflation expectations remain contained. (my emphasis on new language)

Interestingly, they continue to characterize productivity growth as "robust". Yet, the supply side pressure from energy prices and other cost pressures is enough to warrant special mention.

And, not to parse words too much, but I don't think this is accidental. The wording used to be that "longer term inflation expectations remain well contained." The word "well" is gone. I have to believe that is deliberate.

On the balance of risks:

The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.

No change. None. But here's something new...

Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Roger W. Ferguson, Jr.; Richard W. Fisher; Donald L. Kohn; Michael H. Moskow; Anthony M. Santomero; and Gary H. Stern. Voting against was Mark W. Olson, who preferred no change in the federal funds rate target at this meeting.

I believe the last dissent was June 2001 when William Poole (St. Louis) voted against a decrease in the funds rate. I'll look into it and ask if anyone knows the last time someone voted against a rate increase. I'll do some checking myself.

The 10 year bond went down at first, and at this writing is barely on the plus side. At this moment, the Dow is about steady as well. Could it be that the market had this pegged? Steady-as-she-goes? The changes in the wording were stronger in some ways than I would have anticipated and not as strong in others. I think it is very consistent with what Tim Duy and I both said about the possibility that the eventual target (nebulous though it may be) for the funds rate is inching up (while keeping a "measured pace"). That future decisions are going to be data dependent goes without saying. Whether a measured pace includes a pause or not--and at least one member thinks it should--we may still have some distance to go.

Read Tim Duy's remarks at Economist's View:

I'll quote from the conclusion because there's something worth your consideration. Pay particular attention to the last paragraph. The previous two provide the context.

But what about consumer confidence? The UMich Index saw a dizzying slide in September (WSJ subscription only) from 89.1 to 76. The question, however, is to what degree Katrina and gasoline impact consumers’ willingness to spend. This is different from the ability to spend. Consumers may be unhappy because the basket of goods they can purchase has shrunk (or is increasing more slowly), but that doesn’t mean they stop spending. Indeed, non-auto retail sales gained 1% in August – an annualized rate of over 12%! Even if a big chunk of that gain was gasoline, the will to spend remains intact.

A more concerning event would be for consumers to be scared into abruptly raising their savings rate. So far, we have seen little evidence that households want to hold onto a bit more of their paycheck. And even if they did, to what extent would that really change Fed policy? To be sure, many would be calling for the Fed to stop and even reverse course, but higher savings rates will be a necessary part of the rebalancing that (I believe) the Fed expects will happen at some point. Remember, the US is currently consuming roughly 6.4% (the current account deficit) more goods and services than it produces. I doubt anyone at the Fed believes such a situation can continue indefinitely.

In practice, I suspect that rebalancing will require slower demand growth to eliminate this gap – implying a risk that the Fed will raise rates higher in a deliberate attempt to hold growth lower than at any time in recent memory. I think this will come as a surprise to many, but in my opinion the Fed has been sending signals left and right that a change is coming. And, if estimates of potential growth are falling as well, as I read into San Francisco Fed President Janet Yellen’s speech last week, that change may be coming sooner than expected.

So I re-read Yellen's speech. Yes, she talks about the revisions to productivity growth. Here's a quote. You decide what it means.

Recent data revisions lowered estimates of productivity growth over 2001 to 2004 somewhat and reveal a deceleration in productivity growth over the past year or so. These revisions probably warrant a modest decrease in our estimates of structural productivity growth—the underlying noncyclical portion of productivity which is most relevant in assessing inflationary pressures. That said, it's very encouraging that even after a downward adjustment, structural productivity still appears to be growing somewhat faster than the robust rates achieved in the second half of the 1990s, and it remains quite strong by historical standards.

"Faster than the robust rates achieved in the second half of the 1990s" does not suggest enough of a revision to warrant a significant slowdown. If we are really talking about a quarter of a point drop in the growth of potential, do we believe we know enough about the effects of the increases already in the pipeline and those that are coming to be able to say with confidence that we should pick up the pace of rate increases? Consider also that capacity utilization is not yet at late 1990s levels (see Kash at Angry Bear)

So I'm curious as to whether Duy thinks the pace of increases will actually quicken, or the (as yet unstated and rather nebulous) target has shifted up, or both. I'll lay my cards on the table that I could very well see a shift up of the target--what the Fed would consider a "neutral" funds rate. But I'm nervous about quickening the pace just yet. As gas prices retreat from the post-Katrina spike, expectations should hopefully come back in line. It's clear were the interest rate trajectory was going before Katrina. The argument to shift to a higher trajectory is not compelling to me right now, whereas a shift to a higher target (at a "measured pace") is certainly reasonable. Such a view would not preclude a pause if growth slows suddenly, as long as we're clear that it is a pause and not a stop.

Duy also writes:

David Altig notes that the previous outlier in inflation expectations was a short-lived but sharp drop following 9/11. It is worth remembering that the Fed followed the attacks with aggressive rate cutting. Wouldn’t the appropriate strategy now be the opposite?

Not necessarily. The immediate and urgent response of the Fed to 9/11 is more attributable to the provision of liquidity to head off the potential for systemic risk in the financial markets. That they then held rates so low for so long after inflation expectations returned to normal is seen by many as fueling the housing bubble and perhaps the incipient rise in inflation now rearing its head. To be sure, the risk to the financial markets post-9/11 posed some unusual concerns and the immediate response was probably the correct one. But given the known difficulties in changing the course of policy, the risk of overcorrection is great. I would be very cautious about applying such a policy change with urgency in the present setting unless there is evidence that the change in inflation expectations is not a blip and not an over-reaction to the temporary gas price spike. If expectations stay this high for a month or two, all bets are off. If they come back in line, stay the course.

From Reuters:

Rate-setting members of the Federal Open Market Committee who gather in Washington on Tuesday, while mindful of Katrina's devastation, are expected to look past it to their goal of keeping prices stable and opt for an 11th straight quarter-percentage-point increase in the federal funds rate.

"The Federal Reserve cannot address directly supply disruptions and really the best support they can give in this situation is to keep the economy on a sound footing with low inflation," said Lynn Reaser, chief economist for Bank of America's Boston-based Investment Strategies Group.

The federal funds rate -- the U.S. central bank's key monetary policy tool for influencing borrowing costs throughout the economy -- now stands at 3.5 percent.

If this week's meeting had come in the immediate aftermath of Katrina, when calls were loudest for a compassionate act like a pause in rates and the economic fallout of the disaster was still evolving, the outcome might have been different.

Interesting thought. However I don't believe it is necessarily true. See below.

But Fed officials indicate they see the economy recovering from a slight dip in the second half when reconstruction kicks in fully early next year.

"Right now we're already starting to see that rebuilding is under way and energy prices are moving lower so that makes it easier for them to stick to their strategy," Reaser said. "They will likely conclude that the economy is showing a great deal of resilience and that it is able to withstand a higher level of oil prices."

Yes. Keep in mind that the current decline in energy prices (gasoline, especially) is just reversing the large spike that occurred after Katrina. Don't look for energy prices to trend lower for long. They will probably resume the same upward trend they were on before as we move into the fall and winter. (Much to the chagrin of those in colder climates.) In the long run, Katrina's impact will be minimal. The Fed should focus itself on the long run inflation picture (as it has been), ergo, it will probably be business as usual. Whatever trajectory they had in mind for interest rates into 2006 is probably the one they will stick with. To change course in response to Katrina's short run impact is the sort of fine tuning I wouldn't expect them to do.

A Reuters survey on Thursday of Wall Street's primary dealers found 16 of 21 expect a rate increase on Tuesday. On Friday, Goldman Sachs somewhat grudgingly joined those forecasting a rise, but noted that an energy-price shock worsened by Katrina and greater economic uncertainty had at least "created a rationale for a pause."

See above. If, before the hurricane, you thought that it was time to slow down the measured pace rather than keep it the same (or even pick up the pace), the hurricane might have added some weight to your argument. Perhaps Katrina strengthens an already existing rationale for a pause sometime by year's end, but I don't see it creating a rationale for a pause on Tuesday.

Skipping ahead...

Economist Dean Maki of Barclays Capital in New York had little doubt a rate rise was on the way.

"They will keep the measured pace and accommodative language in place," he predicted. "They still think that policy is accommodative, for one thing."

"Accommodative" is central banker talk for rates that are still adding stimulus to the economy.

Maki, a former Fed board economist, said he expected that the Fed will in its post-meeting statement "discuss Katrina ... but indicate they expect the impact to be transitory."

Quite likely. Such a statement could give them the opening to use language that would indicate either a change in the balance of risks (less likely in my mind) or simply that the the pace of rate hikes could slow (while still remaining "measured"). I am really looking forward to seeing how they word the statement because I'd be a little shocked if it remains the same as it has for the last few meetings. They have some inertia to overcome--any change will be seen as rather big news. And yet, change--sometime this year, early next year at the latest--is almost inevitable.

The legend gets cut off, and it really doesn't reduce well (I tried), so click the image to see all of the legend.

After some post-Katrina doubt, the Iowa Electronic Market appears to be favoring a Tuesday rate hike. Compared to the chart at macroblog, it appears that IEM participants were a little late in reacting. The dip in the price of the "up" contract is several days after the market started to react. It was also comparatively short-lived. Interesting.

From the NY Times

With few economic reports due this week, the Federal Reserve has the stage pretty much to itself. But even if the calendar were full, it would be hard to deflect traders' attention from the first formal opportunity to gauge the Fed's thinking on interest rates and the economy since Hurricane Katrina.

Stocks have rallied since the hurricane, at least partly in the hope that the Fed's rate-setting panel will end its streak of 10 consecutive quarter-point rate increases when it meets on Tuesday. That is the expectation of Henry J. Herrmann, chief executive of Waddell & Reed, the asset management firm, but he does not think that the Fed will stand pat for long.

"They'll find some reason to go on hold and signal at the same time that the economy is continuing to do well and that just because they are passing this time doesn't mean they won't raise rates again," he said.

Ultimately, he said, repairing the damage caused by Katrina is likely to result in a new growth spurt.

"Based on everything I'm hearing about the government programs that are going to be put in place to restart New Orleans, you could make the argument that the economy is going to be hurt in the short term," Mr. Herrmann said, "but a reasonable person would conclude that there is then going to be an acceleration" in growth.

The number I'm hearing is $200 billion in anticipated federal spending. But is that meant to be disbursed all in one year? It looks like about $51 billion has been appropriated already. Certainly there will be more in the next 12 months, but how much more? It's an important question. Remember that the first appropriation for the Iraq war was around $80 billion. By now spending on Iraq is certainly in the hundreds of billions, but has been spread out over the 2 1/2 years since the beginning. Estimates of the cost of the Iraq war vary, but for sake of argument, let's call it $100 billion per year. It would seem reasonable, given the figures quoted above, that the spending appropriated for the clean up of Katrina will be at about that level as well. At least it is reasonable to expect them to be on the same order of magnitude. And yet, the spending on rebuilding after Katrina will come after a period of hurricane-induced slack in the Gulf region. This would tend to mitigate any national inflationary effect. One could reasonably argue that Katrina will be less inflationary in the long run than the Iraq war.

Yet it seems to me from what I've been hearing that the spending on Katrina is being regarded by the media and the pundits as much more inflationary than spending on Iraq. Yes, there were (and are) some who point out that the spending on Iraq could be an engine of growth and dangerous to price stability. But those voices are scarcely being heard in the din over Katrina's effect.

Now I wouldn't characterize the Iraq war as an economic growth engine, per se. It's impact on growth and inflation is small but positive. As a driver of GDP growth lately, it pales in comparison to consumer spending driven by the housing boom (or bubble, if you prefer). Why is Katrina expected to be so different?

More evidence that Katrina is expected to be different can be found at macroblog. Altig shows that in the last few years there have been two major spikes in consumer expectations of inflation. After September 11, people expected a big drop in inflation. After Katrina there was a big jump. (There was some volatility around the start of the Iraq war, but nothing as big as the other two spikes.) Furthermore, the aftermath of Katrina is causing a jump in 5 to 10 year inflation expectations that the Iraq war did not! To me, this seems a little backwards. In 5 to 10 years, Katrina will be a painful memory with the requisite spending tapering off, but the Iraq war may very well still be with us.

I will grant that it is possible that in the aftermath of Katrina a lot of economic chickens are coming home to roost. People are recognizing that Iraq and Katrina together make a powerful one-two punch to the budget. No argument there.

Even so, the reaction is hard to explain. Even harder to explain are statments like this, again from the Times article.

As is often the case when the Fed's policy makers announce their rate decisions, the accompanying statement is likely to carry more weight than the decision itself. If the Fed holds steady and hints that further increases are not necessarily in store, stock prices could benefit, Mr. Herrmann said.

Well, yes, the stock market would party like it was 1999 on that news. But if you believe what Herrmann was saying earlier about the "acceleration in growth," what others are saying about Katrina's inflationary impact, and the consumer inflation expectations both long term and short term, how do you regard it as even possible that the Fed will stop now and hint that further increases are not necessarily in store? Admittedly, Herrmann may not believe that will happen, but even mentioning it seemed like a non sequitur.

Both views (hike rates relentlessly because Katrina was a catalyst for more inflation or stop altogether becauase Katrina was a catalyst for slower growth) are clearly present out there. At least one of them is wrong. Perhaps both are wrong. In any case, we will soon get a better idea of what the FOMC thinks, and it causes me to make the only prediction that is almost 100% certain to come to pass.

On Tuesday, we will have a lot to talk about.

(My prediction that is admittedly less than 100% certain to come true still stands about the same as before--another increase, possibly with language indicating the measured pace may slow. But that last part is no sure thing.)

Here are some actual ones...

US Aug producer prices up 0.6 pct pre-Katrina (Reuters)

Producer prices tame, trade gap shrinks (Reuters)

Doves Win a Round as PPI Arrives Light (TheStreet)

Hmmm... can't resist quoting from this one:

Solely on the basis of Tuesday's wholesale price inflation data, the way is cleared for the Federal Reserve to take a break from its rate-tightening campaign at its Sept. 20 meeting

Uh, yeah. Not sure I'd go that far. Even though I've been looking for a pause sometime in the next few months, I don't think it will be next week, nor do I think this data clears the way for it.

"It's another month of contained inflation at the wholesale level, and pipeline pressures are decelerating. There is so far little evidence of high energy prices getting down to core inflation," says Michael Gregory, fixed-income strategist at BMO Nesbit Burns.

...

"This is telling the bond market that first, the Fed has a little more wiggle room when dealing with core inflation. Second, it may not have to raise rates as aggressively in the long run; it may even be able to pause in the short-term," Gregory says.

If you are willing to stick with this article to page 2, however, you'll find...

As noted by Wachovia chief economist Jason Schenker, the report did not capture the industrial price shocks resulting from Katrina, including soaring gasoline and natural gas prices. The September report will see a predictably huge jump across the board in producer prices.

Furthermore, the report did show wholesale inflation was already gaining ground in August, if one considers that the year-over-year rate of producer price increase was 5.1%, the highest rate since December 1990. "This high level of price increases is likely to motivate the Fed to continue their measured rate of rate hikes," Schenker says.

So, the bottom line is that I'm not ready to call off the hounds yet. Neither is Reuters.

US rate futures confident of Sept Fed hike

These headlines use words like "shoot" and "spur". Not exactly comforting.

Gas costs spur Aug. wholesale inflation (BusinessWeek)

US producer prices shoot higher, trade (Financial Express, India)

Our neighbors to the north don't seem too concerned though,

U.S. producer inflation benign (Globe and Mail)

What does all this tell us? Not much. Despite the wide range of headlines, the stories pretty much agree (even TheStreet if you read on to page 2). We are left with confirmation of what we already knew. The energy component of the PPI has been jumping due to oil price increases. Pass-through, to this point at least, has been minimal. Anyone who read the Beige Book knew that. We also knew that this data was collected before Katrina. Next month is likely to be a similar, if not worse, story for energy prices. As for the pass-through, we'll have to wait and see. But we all know (you, me, and every member of the FOMC) that this data does not represent any potential pressures in the pipeline from Katrina.

We can (and we have) argued about the likely magnitude of those effects. They could be noticeable. We'll probably need two or three months of post-Katrina data to be able to get a sense of it. Thus, I would expect, ceteris paribus, that the Fed could hold the line, perhaps changing the language of the statement and give us another couple rate hikes before pausing. And then, pausing if and only if the post-Katrina data suggests that it would be wise.

December still seems like the preferable timing for a pause if there is to be one. But I am certainly open to re-evaluate that position as more data becomes available. For now though, this additional data point doesn't move me off of my expectation of a rate hike next Tuesday. I will be really surprised if they don't stay the course.

However, I will also be really surprised if the language of the statement does not reflect these discussions taking place in the media, among market analysts, and in the economics blogs. The last few statements have been remarkably similar--a cut and paste operation. But now, the market seems divided. If ever there was a time for clear language, now it that time. My guess is that they're working hard on that language even as we speak.

If they succeed, you'll know it by the lack of variation of the headlines.

Full text of the speech here. I'm excerpting more than usual, so scroll down for my comments (and updates from other blogs). She begins by talking a little about Fed operations in light of Katrina. Then comes the policy talk:

Now let me turn to the economy and monetary policy. Even before Hurricane Katrina and all that has followed, I would have said that the conduct of monetary policy had reached a challenging phase. We had gone through a period in which inflation was well contained but the economy had a lot of slack. In that phase, it was obvious that policy needed to be highly accommodative. Then, as slack diminished, it seemed equally obvious that the Fed needed to gradually remove policy accommodation—"normalizing" the stance of monetary policy. The goals of these policy actions, of course, are to set the economy on track so that inflation stays low and excess slack in the labor market is absorbed. As that occurs, real output growth must converge toward its potential rate for inflation to remain under control, which, in turn, requires that monetary policy reach a so-called neutral stance. Such a trajectory still remains a plausible, even probable, scenario. However, as we've come closer to these goals, the appropriate policies are not as obvious as they were before, as the potential for undershooting or overshooting the goals looms larger. Indeed, uncertainties and risks that could complicate things considerably were evident even before the havoc unleashed by Hurricane Katrina, so our approach during this phase must be particularly dependent on information from incoming data.

...

Monetary policy, unfortunately, has little scope to cushion the immediate economic fallout from such a severe and sudden blow to a region, because monetary actions can't be directed at a particular area of the country, and their effects take time to be felt. It is fiscal policy—government spending and transfers—that is necessary to address the immediate needs of the affected areas. Monetary policy may come into play, however, in counteracting those impacts from the hurricane that continue over time and affect the country as a whole. I'm thinking particularly of the hurricane's effects on energy prices, which could be a threat if their effects are long-lasting. The Gulf Coast is important to our nation's energy supplies, and the associated problems are coming at a time when oil prices were already high.

...

To offset the negative impact on spending stemming from oil and the other drags I mentioned, monetary policy had to remain highly accommodative for a substantial period—stimulating interest-sensitive sectors, particularly consumer durables and housing. Over time, however, as slack in resource use diminished—that is, jobs have grown and capacity utilization has risen—the FOMC has gradually been able to lift its foot off the accelerator, removing policy accommodation. At each of its last ten meetings, the FOMC raised the federal funds rate by a quarter of a percentage point, bringing it to three and a half percent today.

As I said, during the process of removing accommodation, incoming data have become increasingly influential in my own assessments of the further policy measures that are needed to move the economy toward this desirable trajectory.

For example, data during the late spring and early summer suggested that aggregate demand was stronger than had been previously thought, implying greater momentum in spending. Moreover, the data showed a drop in the pace of inventory accumulation, especially for autos. Therefore, most forecasters were predicting fairly rapid growth for the second half of the year, as firms rebuild their inventories, with a return to trend-like growth in 2006. This potential for a bulge in growth in the second half of 2005—with labor markets apparently already near full employment—was seen as raising inflationary risks.

Now, of course, developments in the Gulf Coast come into play, altering the expected pattern for the national output data. Disruption of production in the Gulf will undoubtedly slow growth somewhat in the second half—a common estimate is that it will depress national real GDP growth by around one-half to three-quarters percent. This is likely to be followed by a surge in growth as the government-assisted rebuilding kicks in—hopefully before too long.

...

Let me now turn from the real side of the economy to inflation, again emphasizing how incoming data have influenced my own assessment of the appropriate path for monetary policy. I'll focus particularly on something called the personal consumption expenditures price index, excluding food and energy. I realize I just said a mouthful, and I apologize. But it's important to mention it, because it's a comprehensive measure of core consumer inflation that the Fed carefully monitors. That measure rose by 1-3/4 percent over the last 12 months, suggesting that inflation has been relatively well-contained over the past year. And core inflation has dipped a bit over the last few months.

Of course, the issue for policy is not so much where inflation was in the past, but rather where inflation is headed. In this regard, it seems likely that, even with inflation expectations well contained—which they have been according to most indicators—higher oil prices may be partly passed through to core inflation at least for a time. Supply disruptions emanating from the Gulf Coast disaster may also affect the prices of building materials and transportation services. Two further key influences on inflation are productivity growth and the pace of compensation growth, since both affect the behavior of business costs. Recent data revisions lowered estimates of productivity growth over 2001 to 2004 somewhat and reveal a deceleration in productivity growth over the past year or so. These revisions probably warrant a modest decrease in our estimates of structural productivity growth—the underlying noncyclical portion of productivity which is most relevant in assessing inflationary pressures. That said, it's very encouraging that even after a downward adjustment, structural productivity still appears to be growing somewhat faster than the robust rates achieved in the second half of the 1990s, and it remains quite strong by historical standards.

With respect to labor compensation, my sense from the data and our business contacts is that cost pressures remain in check, although recent data also give conflicting signals. One key measure, the Employment Cost Index, has recorded only modest increases over the past year. A second more inclusive measure of compensation shows a more substantial rise. It is also worth noting that, over the last few years, an unusual situation has emerged in which profits have risen at an exceptionally rapid pace in comparison with labor income, pushing up capital's share of GDP to a very high level by historical standards. A more rapid rise in compensation per hour could be part of the process by which labor's share of income returns to more normal levels, hence unthreatening from an inflation standpoint. As we assess the likely behaviour of wage pressures going forward, we must also factor in the influence of slack in labor and product markets. The decline in the unemployment rate to 4.9 percent in August, coupled with some improvement in measures such as the employment-population ratio and industrial capacity utilization, suggest that while a "whisker" of slack may still remain, we probably can't count on slack to hold inflation down.

Taking all of these factors into account, my overall assessment is that core inflation—that is, excluding food and energy—seems relatively well contained at the present time. However, there are a myriad of uncertainties about how things will unfold over the next year or two, and the uncertainties on the upside have only gotten bigger since Hurricane Katrina slammed into the Gulf Coast.

...

Let me close by summarizing where I think the economy is now heading and the role of monetary policy in guiding its evolution. I have emphasized in this talk that a number of risks cloud the outlook. The tragic disaster in the Gulf region tops the list of risks to the national economy at this stage, given the importance of this area to energy, trade, and transportation. I have also discussed risks relating to housing markets and the current configuration of interest rates. Even taking these risks into account, the economy overall, in my estimation, is doing reasonably well and could settle into a highly desirable pattern of full employment, trend-like real GDP growth, and well-contained inflation. The job of monetary policy is to foster exactly such an outcome.

Though it seems like I'm excerpting a lot, there is really a lot more in the full text, including some statements on the housing market. (The speech was given in San Diego.) All in all, it seems to me to be a fair assessment of the situation as we know it right now. It seems just slightly less hawkish than Moskow's speech yesterday. That's just my impression. What's yours?

For example, I keyed on Moskow's comment, "Putting it all together, I'm concerned about core inflation running at the upper end of the range that I feel is consistent with price stability." Nothing I saw in Yellen's speech rose to that level of concern.

Overall, I think Yellen nails it pretty well. Let the blog commentary begin.

UPDATE: Mark Thoma leads with: "San Francisco Fed’s Yellen Sees Inflation Risk Ahead." He is keying on the Reuters story which pulled a quote that makes me want to beg for pgl's (Angry Bear) reaction. They pulled this quote:

While a 'whisker' of slack may still remain, we probably can't count on slack to hold inflation down.

Again, it may be a matter of perception, but I think that's about as hawkish as Yellen gets and that's not as hawkish as Moskow.

And like I said, I think it's a fair assessment. I wouldn't want to count on whatever slack remains to keep inflation down either. More rate hikes are necessary. On that we agree.

Mark also says:

I read this as expressing more concern over the potential for inflation than the potential for economic slack.

Definitely. I do think that we're getting closer to that "sweet spot" of potential GDP, and that will tend to equalize those risks. I think Yellen would agree, as she says:

...as we've come closer to these goals, the appropriate policies are not as obvious as they were before, as the potential for undershooting or overshooting the goals looms larger.

That's the statement I've been looking for someone to make.

At least in the short term there's not going to be much effect, but that has a few people bothered. Check out this Wall St. Journal article and poll (of course no web poll is all that scientific). Mark Thoma and David Altig both take note of the article and the poll respectively.

In the days since I commented on the possible effect of Katrina on monetary policy, we have learned much about the true nature of the disaster. The loss of capital and consequent loss of wealth to the economy is going to be truly catastrophic. The resources needed to rebuild will truly be immense. Folks, there is a level effect and a growth effect at work here. From where I sit, we haven't even begun to figure out how long it will take those effects to play out, what the dynamics will be, and therefore, what policy steps will need to be taken. I think it's reasonable to say that there will be significant short term negative effects on GDP, at least for the remainder of the year. The replacement of broken windows will probably not begin in earnest until next year. To those who repeat the mantra that the rebuilding will add to GDP, please remember that we're replacing what is lost. My caution about making too much out of the increase in GDP goes beyond just the mere fact that GDP is not a perfect measure of utility or welfare. I also want to point out that an increase in activity later is making up for the lost use of capital now. The timing of activity is changing. But even in a disaster on the scale of Hurricane Andrew, such a change in the timing of activity barely registers on the big picture that the central bank must consider.

Katrina, as we now know, was no Andrew. It could register on the Fed's radar, but less than conventional wisdom might expect, I think. Will Katrina cause economic growth to weaken for a quarter or two? Almost certainly. Will there be an increase in demand later, maybe really ramping up in the spring? Almost certainly. Now, my point in bringing up the Broken Windows fallacy was to say that these two "almost certainlys" put together still leave us worse off in terms of utility. The question of whether the added demand will be large enough to warrant further increases in interest rates is a separate issue. It's an issue that only surfaces in disasters of such incredible magnitude--in the last week, it has become more clear that Katrina is in this category.

In a comment on macroblog, a reader going by the moniker "knzn" (who has also commented here--sound it out, you'll get it) writes,

The situation is complicated somewhat by the fact that not everyone believes the Fed was on the best trajectory before Katrina hit. The conventional view seems to be that, without Katrina, the right thing to do was to raise it, but now the right thing to do is to leave it at 3.5%. My own view is that leaving it at 3.5% was the right thing all along, and still is, but, if anything, Katrina pushes me a little bit in the direction of raising it.

I think that's premature. The increased demand won't materialize for a while yet. But I acknowledge that there could be marginally more pressure on rates in the spring as things really get going. In the meantime, the Fed might want to acknowledge the short term impact with a pause in rate hikes sometime this year with the clear expectation of continuing them after the first of the year (which may turn out to be very good timing).

On that note, there's this from Reuters.

LONDON (Reuters) - The dollar gained against the yen and held steady against the euro and Swiss franc on Thursday as expectations grew the Federal Reserve could continue raising interest rates despite the damage caused by Hurricane Katrina.

Chicago Fed President Michael Moskow said late on Wednesday that U.S. rates must contain inflationary pressures, helping to ease market fears that that central bank would pause in its dollar-supportive rate tightening at its meeting on September 20.

Whether you fear a pause or hope for a pause depends on how you voted in the WSJ poll, I guess.

"The world is coming to a view that the Fed is going to provide more liquidity and interest rates will probably (peak) around 4 percent," said Adam Myers, currency strategist at UBS.

That may not be a peak, but a temporary plateau. Let's see what Janet Yellen has to say later today.

UPDATE: James Hamilton elaborates on his thoughts concerning the impact of Katrina. It deals more with the impact and potential for recession than with monetary policy specifically. It makes excellent companion reading to go along with the other links above.

UPDATE 2: knzn replies that he was actually looking at it from the supply side perspective. We kick it around a bit in the comments.

The word "measured" is in the minutes in a couple of important paragraphs:

The Committee's decision at its June meeting to raise the intended level of the federal funds rate 25 basis points, to maintain an assessment that risks to the goals of price stability and sustained growth were balanced assuming appropriate monetary policy action, and to retain the "measured pace" language was widely expected in financial markets. Over the intermeeting period, however, investors appreciably marked up their expectations for the path of policy, primarily in response to incoming economic data suggesting more strength in spending and output than had been anticipated.

and...

In their discussion of current conditions and the economic outlook, meeting participants noted that aggregate spending appeared to have picked up in recent months by more than anticipated and that current estimates of slack were narrower than those reviewed at the June meeting. In addition, high and rising energy prices were adding to pressures on overall inflation, and energy price increases probably would feed through, at least temporarily, to core measures of inflation. Nonetheless, core inflation recently had been relatively low and inflation expectations remained well contained. Moreover, participants thought that some slowing in final sales was likely later this year as net exports resumed their decline and purchases of automobiles fell back with the expiration of special discount programs. In these circumstances, it appeared that, for now, continued removal of policy accommodation at a measured pace still would likely be sufficient to keep inflation contained, but participants also recognized that the pace and cumulative extent of policy adjustment going forward would depend importantly on economic developments.

But there's more... These are some of the most interesting minutes in quite a while.

Participants viewed the increases in market interest rates over the intermeeting period as an appropriate response to the stronger economic outlook. A few participants voiced concerns that still-low interest rates and insufficient recognition by investors of the dependency of the Committee's policy expectations on economic data were continuing to foster an inappropriate degree of risk-taking in financial markets. Another participant mentioned, however, that recent sluggish growth of the monetary aggregates suggested that the stance of policy was not overly accommodative. Moreover, with a higher proportion of mortgages now tied to short-term rates, it was noted that increases in short-term rates could have a somewhat larger-than-usual effect on spending. On balance, current financial conditions, which embedded expectations of future policy tightening, were generally seen as likely to be consistent with sustained moderate economic growth and containment of pressures on inflation in coming quarters. (emphasis mine)

Ah, there appears to be debate of the sort we've been chronicling. Note how the at this point the minutes are sounding a trumpet call to the market that future policy is going to be dependent on the data. I think that should be crystal clear now. You've been warned.

Participants discussed at length the factors affecting costs and prices. Although uncertainties about the underlying pace of productivity increases, trends in labor force participation, and the level of potential output complicated the inflation outlook, higher energy prices and reduced resource slack were seen as pointing to elevated inflation pressures. While recent monthly readings indicated that core inflation had been subdued, a number of participants noted that underlying core inflation appeared to be running at a pace around the upper end of the range they viewed as consistent with price stability-an assessment that was reinforced by the recent upward revisions to historical data on core PCE inflation. Participants commented that an increase in inflation from recent rates could have especially adverse effects on longer-run economic performance.

Ah, to have been a fly on the wall for that discussion, eh, PGL?

While most participants viewed the risks to inflation as having ticked up over the intermeeting period, many also cited factors that, in concert with the likely continued removal of policy accommodation, would tend to hold inflation pressures in check. For example, few indications had emerged recently that businesses had enjoyed any significant increase in pricing power, and the continuing expansion of global trade was seen as an important factor limiting firms' ability to pass through cost increases. In these circumstances and with markups at relatively high levels, a substantial proportion of any increases in business costs might well be reflected in narrower profit margins. Moreover, the recent relatively low monthly readings on core inflation and modest wage pressures, at least by some measures, suggested that some slack remained in resource utilization. Despite the rise in oil prices and quickening pace of economic activity, both market- and survey-based measures of inflation expectations seemed to remain quite well anchored.

Seems like most of the discussion was about inflation, which is the appropriate thing for a central bank to talk about since it's where they have the biggest effect in the long run. The inflation picture is not unambiguously benign. However, it appears to be held in check, perhaps more than they would have expected given strong GDP data and higher oil prices.

In the Committee's discussion of monetary policy for the intermeeting period, all of the members favored raising the target federal funds rate by 25 basis points to 3½ percent at this meeting. Even with this action, the federal funds rate would remain below the level that members anticipated would prove necessary to contain inflation pressures and keep output near potential, and thus in all likelihood further policy action would be required. However, the pace of future policy moves, although likely to be measured, as well as the extent of those moves, would depend on incoming data.

It's not over, folks. But then, you knew that already, right?

In discussing the statement to be released after the meeting, members agreed that it was appropriate to highlight the apparent strengthening in aggregate spending. Policymakers exchanged views on the characterization of labor market conditions in light of recent employment reports and other indicators, but members ultimately concurred that the description of labor markets as "improving gradually" remained appropriate. Members agreed that it was appropriate to acknowledge the recent relatively low monthly rates of core inflation, but also to emphasize that inflation pressures remained elevated. As in past meetings, there was some discussion about the desirability of including forward-looking language in the statement, but members agreed to retain the forward-looking language for now.

All in all, there are a few tidbits in here that haven't come out in previous minutes. I think these minutes paint quite a picture of how the Fed is concerned that the market needs to take note of the fact that upcoming policy moves are going to be dependent on incoming data. As I said above, you've been warned. Energy prices continue to be a point of interest, and probably will be for some time. Don't look for the Fed to ease (or let up on the increases as the case may be) just to give the economy a break from high oil prices, at least not at this point.

So we know a little more today than we did yesterday. The rate hikes are clearly not over. And some additional increase is probably appropriate given the big picture painted by the data. I still would advocate for a pause in the action in December even if they resume in 2006, just to give the economy a chance for the last couple hikes (which were not anticipated until a few months ago as opposed to a year ago) a chance to sink in.

Check out macroblog:

Randy Moore from Aspen Publishers brought my attention to a special question on just this topic that was addressed in the latest edition of Blue Chip Economic Indicators. With his permission, I share the results with you:

Q: In the FOMC’s policy statement, will the phrase “measured pace” be dropped before, at the same time, or after the phrase “monetary policy is accommodative” is dropped from the statement?

Response: Before: 8.9%; At the same time: 82.2%; After: 8.9%.

Q: Will the FOMC drop the phrase “measured pace” and/or “monetary policy is accommodative” from its policy statement before, at the same time, or after it pauses in its tightening cycle?

Response: Before: 35.6%; At the same time: 57.8%; After: 6.7%.

Very interesting. I'd answer "at the same time" to the first question. The second question is a bit more difficult to answer. A few months ago, "before" would have have my clear choice, but I've been revising my priors on that after each of the last three meetings.

And if you've been a regular reader you know that it's been on my mind. Here's macroblog's take.

The answers to the second question are interesting, as they suggest that most forecasters think the measured pace language does not much constrain the Committee meeting-to-meeting. Here's something I'd like to know: Do the Blue Chip responses to this question reflect the opinion that the FOMC will find plenty of alternative ways to signal a pause if the time is drawing near -- as William Polley suggests? Or does it suggest that the press-statement language has become largely meaningless?

Well, I sure hope it's the former. The latter would be one step forward and two steps back.

UPDATE: Dave Altig (macroblog) also links to the WSJ online today.

By a narrow margin, economists surveyed in the latest Wall Street Journal Online forecasting survey say they think there's a greater risk the Fed will go too far in its campaign of rate increases than it will stop short of what's needed. About 54% said they see a greater risk of the Fed moving too aggressively in the next year, while 46% say the bigger concern is rates will be kept too low...

Ethan Harris of Lehman Brothers Inc. worries that the Fed will overshoot, but he says that the problem is the central bank won't know if it has gone too far until it sees subsequent economic data. "There's a danger that the Fed will keep pushing the brakes until they finally work," Mr. Harris says.

If you read my blog earlier this week, you'll understand me when I say, "no comment necessary."

Read it here. I reproduce the key paragraphs below.

The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Aggregate spending, despite high energy prices, appears to have strengthened since late winter, and labor market conditions continue to improve gradually. Core inflation has been relatively low in recent months and longer-term inflation expectations remain well contained, but pressures on inflation have stayed elevated.

The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.

Analysis to follow.

UPDATE: The risk assessment is identical to the last press release. ("Measured pace" lives!) The outlook is almost identical. I print it again below with the previous release's words in parentheses and italics where they differ. New language is in bold.

The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Aggregate spending, despite high energy prices, appears to have strengthened since late winter, (Although energy prices have risen further, the expansion remains firm) and labor market conditions continue to improve gradually. Core inflation has been relatively low in recent months and longer-term inflation expectations remain well contained, but pressures on inflation have stayed elevated. (Pressures on inflation have stayed elevated, but longer-term inflation expectations remain well contained.)

What is the message? Economic performance has been good despite high energy prices, and the high energy prices haven't spilled over into the rest of the economy (core inflation remains low). Other than that, it's pretty much what we've seen before. So far, the market is yawning. I guess that's an appropriate reaction. Stay tuned to see if there is any change once the words sink in.

UPDATE #2 (1:50pm): The 10 year bond is actually up a few ticks. Considering that this morning, the Forbes piece that I quoted earlier seemed to be of the opinion that the bond market is looking for a hawkish statement one might consider the current reaction to be a little strange. I didn't see anything all that "hawkish". The only difference between this statement and the previous one on inflation is the statement today that core inflation has been low in recent months. Of course, there is nothing in the statement to suggest that the rate hikes are over either. And maybe that's what the market really wanted to see. I'm not jumping up and down over that. Though I don't think another one or two quarter point moves will throw us into a tailspin, I worry that the FOMC has painted themselves into a corner linguistically. How are they going to break it to the market that the rate hikes are about to pause? Granted, that may be irrelevant at the moment if the fed funds futures market is correct, but it's something they'll have to deal with eventually. The end result of this statement is to tell the bond market "don't worry; be happy" and the yield curve flattens out again. This can't go on forever.

But it looks like it will go on for a few more weeks. Right now, I am anticipating a scenario where we get two more rate hikes to get the funds rate to 4% and then a pause at the December meeting. By December, the housing market might be softening and inflation will hopefully still be contained. The holiday spending season would be a good time for a break in such a long (by that time almost 18 month) string of rate hikes. Many people regard 4% as pretty close to neutral, and that would be a good time for Greenspan to hand over the reins to his successor.

Of course, we don't have a successor yet, but that's a topic for another day.

But that scenario presupposes that the Fed can give the market a hint that the rate hikes to which the bond market seems to have become addicted are about to end. My guess is that those hints will be dropped in speeches by Fed governors and presidents. So far I haven't heard much. It will indeed be an interesting autumn for monetary policy. I just hope it doesn't give way to the winter of our discontent.

UPDATE (yet again): For more, check out Mark Thoma, and PGL at Angry Bear. The Capital Spectator is even more worried than I am.

UPDATE: Still more econ bloggers checking in. See also macroblog, New Economist, and Brad DeLong.

So here we are again on the day of an open market committee meeting. Not much to talk about in the way of what they will do, but plenty to talk about in the way of what they should do. Is the current round of tightening too much or not enough?

First, the news... (CNN)

Before the Fed meeting, the Labor Department announced Tuesday morning that unit labor costs, an important measure of inflation in the job market, climbed 1.3 percent in the second quarter. Economists expected a 2.75 percent result.

Productivity also climbed 2.2 percent during the second quarter, ahead of economists' expectations of 2 percent.

Macroblog has more, including links to other news articles from this morning. All in all, I'd say the morning news has my day off to a good start.

But as Jerry Garcia famously sang, "Every silver lining's got a touch of grey." You just can't get away from the long standing notion that a strong economy leads to inflation. Dave Altig's (macroblog) post points to a Bloomberg article that makes both of us cringe a little.

Reports in recent weeks have shown that even after nine rate increases since June 2004, with a 10th expected tomorrow, the Fed hasn't been able to slow the economy. The 10-year note yields less now than it did when the central bank began raising interest rates. The government reported that house prices in June jumped by the most on record and inflation is running at the high end of the central bank's estimates.

...

"The Fed is going to have to raise rates however high as necessary to get an effect on the housing market," said Jan Hatzius, a senior economist at Goldman Sachs Group Inc. in New York. Goldman forecast a year-end 10-year yield of 4.90 percent.

Count me in the camp that believes that pricking the housing bubble is not the Fed's objective here.

And here's an interesting observation (Forbes)

The market's attention will focus firmly on the FOMC's accompanying statement, with many expecting a slightly more hawkish tone in light of recent strong US economic data.

"People are thinking that the Fed may adopt a slightly more hawkish tone, and that is giving the dollar a bit of a boost at the moment," said Gary Noone, currency analyst at Informa Global Markets.

It doesn't get much more exciting than this, folks. In the overall scheme of things, not a lot has changed in the last 5 months. The labor market has improved (albeit more slowly than some would prefer) and GDP growth has been pretty strong (but not "overheating"). Inflation has, despite a number of anxious moments, largely remained in check. And here we are again with the bond market anxious--expecting hawkish words from the Fed to reassure them.

Here's a Reuters piece:

Treasuries have taken quite a whipping over the past two months, with benchmark yields spiking 40 basis points higher as expectations of an economic soft patch gave way to hopes for stronger growth in the second half of 2005.

A barrage of positive economic data has convinced investors that the economy is on a strong enough footing to allow the Federal Reserve to continue raising interest rates for a considerable time to come.

Coupled with upward revisions to inflation, the numbers are shifting the focus of the interest rate debate from a discussion about when the Fed could pause to a debate about just how far it might go, analysts said.

"The minutes of the upcoming meeting may show that a search for neutrality is being replaced by an inquiry into whether FOMC policy will need to turn restrictive in the coming quarters," argues Bruce Kasman, global head of economic research at JP Morgan.

Fed forecasters have adjusted their expectations for further monetary tightening accordingly to reflect a chance the central bank might actively nudge rates higher well into 2006.

What strikes me as odd, and a bit worrisome, is the idea that the economy has to hit a "soft patch" (for lack of a better word) to give the Fed the signal to stop raising rates. If Calculated Risk and Paul Krugman are correct that the housing market is starting to lose steam, then we might want to tread carefully.

I think that market forces (from yuan revaluation right on up the list) are going to push the 10 year yield up a bit regardless of what the Fed does. A pause in rate hikes might be just what we need in the 4th quarter. We've got a lot of rate increases in the pipeline. Although most of the increases were "priced in" some time ago, we need to remember that most of us weren't expecting to be where we are now when rates started rising a year ago. I'm not saying that it's time to stop--just time to pause. It's time to give the yield curve a little time to catch up. If market forces are gearing up to push long rates up anyway and the Fed is overzealous, that's just going to cause more problems.

Time to get away from the notion that a soft landing has to include a soft patch. As James Hamilton notes,

So where does that leave us right now? The Fed's expected rate hike next week will narrow the spread further. My nervousness about that is allayed somewhat by last week's favorable economic data. I'll be more nervous if the Fed raises rates again at the following FOMC meeting, and even more nervous if they raise rates again in November.

I get nervous when people talk about "slowing" the economy when real GDP growth has been remarkably stable in the (roughly) 3-4% range for a year and a half and some measures of the labor market have been slow to recover. Slowing right now would not be good, and it's exactly what would happen if you put one or two extra rate increases into the pipeline before we understand the effects of a year's worth of rate hikes.

I started the day feeling pretty cheery, and now I feel nervous. Well, check back in an hour and see if the FOMC press release has me in good spirits again. More importantly, check back to see what kind of spirits the market is in after the release.

...and don't expect him to say that the rate hikes are over.

Via Bloomberg:

Greenspan will likely use his semi-annual monetary policy report to end any lingering notions the central bank is almost finished lifting its interest-rate target after nine increases since June 2004, investors said. Yields, which move inversely to debt prices, have been little changed the past two months as bondholders sought clues as to how much rates will rise.

This "could be the spark that causes 10-year yields to rise out of their range," said Colin Lundgren, who helps manage $100 billion as head of institutional fixed-income at American Express Asset Management in Minneapolis. Greenspan testifies in Washington on July 20.

We'll see. I hope C-Span carries it. So far, they don't show it on their schedule. Stay tuned.

The speech isn't that long. As they say, read the whole thing. This part seems particularly relevent to some issues the blogosphere has been buzzing about this year.

Starting with the policy statement following its meeting on August 12, 2003, the FOMC began to provide firm guidance as to the future direction of policy. The statement said that the Committee “…believes that policy accommodation can be maintained for a considerable period.” This language was repeated until the statement released on January 28, 2004, when the Committee said that it “… believes that it can be patient in removing its policy accommodation.” That language was continued until May 4, 2004 when the Committee said that it “believes that policy accommodation can be removed at a pace that is likely to be measured.” At its meeting of June 29-30, 2004 the Committee raised the target federal funds rate by 25 basis points and issued a statement repeating the “measured pace” language. That language came to be interpreted in the market as creating an expectation of an increase in the target fed funds rate of 25 basis points at the next FOMC meeting and, depending on circumstances, at the next several meetings. At every subsequent meeting following the June 2004 meeting, through its most recent on June 29-30, 2005, the Committee raised the target funds rate by 25 basis points and repeated the “measured pace” language.

Providing guidance on likely future policy actions is a significant departure for the Federal Reserve. Historically, the Fed and other central banks have been reluctant to provide forward guidance out of a concern that doing so would limit freedom of action in the event of new information indicating that changed circumstances called for a change in policy direction. If the markets have a thorough understanding of policy, including an understanding that forward guidance is conditional on the information available to the central bank at the time the guidance is issued, then markets should not have difficulty in understanding how new information might require policy action that differs from the guidance.

Experience to date with forward guidance has been successful but in my opinion it is too early to tell whether this departure will be successful in the long run. The matter will be tested when changed circumstances require policy action that differs from forward guidance.

I believe that improved predictability of policy has had much to do with improved effectiveness of policy. Poole and Rasche (2000) argue that changes in policy practice have moved the economy toward a rational expectations macroeconomic equilibrium in which the Fed and the markets react in similar fashion to the arrival of new information. Synchronized responses between the markets and the Fed enhance the economy’s adjustment to changed circumstances, thereby increasing economic stability and efficiency. In the years ahead, maintaining and extending improved predictability of policy will be a major challenge for Federal Reserve chairmen.

Can't say I disagree.

King at SCSU Scholars has more on the panel at the WEAI meetings (where this speech was delivered).

Mark Thoma links to a Reuters story about the event.

I only planned to do one post tonight, but this was too good to pass up. Via macroblog comes word that the market might be thinking twice about whether the Fed is done or nearly done raising interest rates.

For better or worse, "measured pace" lives. Check it out. The implied probability of another 50 basis points by October is almost at 60%. This after being in the 30-40% range since late April.

The rather sudden turn in the implied probabilities is not all that puzzling. Clearly last week provided the market with new information. After mulling it over the long weekend, traders are putting that new information into practice.

So is the economy really doing better than market participants were expecting? Maybe. I mean, the bond market is not infallible. For my money, they have been too pessimistic so far this year. But even some Fed watchers are a little surprised. I admit to being less surprised.

In the final analysis, I think what we're seeing here is the market adjusting to information. The Fed has been cryptic about when the rate hikes would stop. That heightened speculation that they would stop soon. The Fed essentially said, "Think again." This isn't a sign that things are going wrong. While it's not a perfectly transparent process, information gets transmitted and the market reacts. What we are seeing is what we teach in our classes.

In a comment over at Mark Thoma's blog, I had one of my better predictions concerning what I thought the committee might say in the statement after the meeting. I missed one thing though, and I think it is important. The Fed (and I think the market too) believes that the increase in energy prices is not likely to translate into long term inflation problems. From the statement:

Although energy prices have risen further, the expansion remains firm and labor market conditions continue to improve gradually. Pressures on inflation have stayed elevated, but longer-term inflation expectations remain well contained.

And in turn, long term expectations are keeping the 10 year yield well contained. Inflation expectations matter, and I haven't seen any indication that the news that the market is responding to has much to do with long term inflation expectations. There hasn't been as much talk about this, but it's a very important point.

I actually see the movement in the fed funds futures and the 10 year in the last few days as an understandable, if not totally expected, move. Just a real-time adjustment in short-term (3-12 month) expectations--not a lot more. I'll just say that for now anyway, any attempt to make this into a lot more is probably much ado about nothing.

I do, however, think that the minutes to the meeting just ended will be worth reading indeed. And I'll report on them here.

Via the NY Times:

One school of thought holds that low bond yields are a harbinger of slowing economic growth, which would reduce demand for credit in the future. Another school holds that global investors have lower inflation expectations than in the past, which reduces the risk of holding long-term bonds. If either theory is correct, the Federal Reserve would have less need to fend off inflation and could stop raising short-term rates at a much lower level than in the past - perhaps below 4 percent.

But yet another theory holds that long-term interest rates may have been depressed by other factors, including a "savings glut" around the world and efforts by Asian central banks to keep the value of their currencies down by buying United States Treasury securities.

If that is true, the flood of foreign money into the country could be diluting the Fed's effort to prevent inflation. That would imply that the Fed needs to raise rates more than many investors are expecting.

...

Wall Street economists are as divided as Fed officials about the proper interpretation.

James Glassman, a senior economist at J.P. Morgan, contends that long-term interest rates reflect the deflationary effects of globalization. "If you think of this in economic terms, East Asia and Nafta have been annexed to the United States. It looks like an economy that has far more excess capacity. Overnight, decisions by the Chinese government are releasing huge numbers of Chinese laborers. That means more excess capacity and a longer time to get back to full employment."

What does this mean for this week's FOMC meeting? The bond market will probably be parsing the words in the statement pretty carefully. Guessing what the wording will be ahead of time is a tough game to play, and I'm not going to do that this time. Back in March it seemed like the market sort of got its signals crossed. Hopefully the statement will be clear enough so that won't happen again. Of course the statements have changed incrementally over the last year, so any sudden change would raise eyebrows. That's the downside of transparency.

Small price to pay.

Oh, and I think "measured pace" stays.

See also Tim Duy's Fed watch at Economist's View.

Blogging hiatus begins today. I'll be back in a few days, hopefully around the weekend. Enjoy the rest of the week.

Macroblog has the weekly update. Note that for one brief moment, it looked like the market was anticipating a pause in the rate hikes until the PPI and retail sales numbers came in. But now it once again looks like the most likely outcome in the eyes of the market is for another 75 basis points by October.

There are 3 meetings between now and October, so the expectation of 25 b.p. per meeting seems to be holding.

I don't think I even need to mention that the implied probability of a 25 b.p. increase at the next meeting is almost 100%.

William Poole of the St. Louis Fed doesn't see a conundrum. Read the whole speech here.

The fact that the 10-year bond has not exhibited a persistent trend over the past 18 months or so while the Fed has been increasing the target fed funds rate by 200 basis points is not evidence that something is awry with monetary policy. Think of the issue this way. At the beginning of a planning period the Fed has in mind a probable course for the economy and expectations about the policy adjustments that will be consistent with long-run policy objectives. Suppose the market has the same understanding as the Fed. Suppose also that events turn out largely as expected. Then, everything goes according to plan, including policy adjustments and the course of bond rates. In fact, in January 2004 the Eurodollar futures contract for June 2005 traded at an average rate of 2.81 percent, which was not far off the target fed funds rate of 3.0 percent set by the FOMC on May 3, 2004.

I am not claiming that the Fed had a firm plan in mind in January 2004 to reach a target fed funds rate of 3 percent in May 2005, but rather that events have simply worked out that way, corresponding rather closely to the market’s best guess as to how events would unfold. In any event, the fact that everything goes about as expected is certainly not evidence of a policy problem.

I would be delighted, as would professional forecasters, for the string of accurate forecasts to continue. But we would be well advised not to forget those forecast standard errors. They have not vanished. With respect to forecast errors, the future is more likely to be like the past several decades than like the past year. If real growth and/or inflation depart significantly from current expectations, then we will see a persistent trend in the bond rate. I hope we do not see such an outcome, for I believe that the current outlook for the economy is quite favorable. I hope that current expectations are realized.

Poole doesn't use the term "soft landing." It's not much of a stretch to think of his observations in those terms though. The bond market seems to have a lot of confidence in the Fed's ability to engineer a soft landing--confidence that, so far at least, has been well-placed. But the final chapter of this episode has not yet been written.

Via Reuters:

"Given the current outlook for the economy, my personal view is that we've not yet reached a neutral policy stance," Guynn said in prepared remarks to the Certified Professional Home Builders in Atlanta. The Fed released a text of his speech in Washington.

...

The Atlanta Fed president added to recent warnings by Fed officials and others about possible regional U.S. housing bubbles. Investors gambling that housing prices will soar indefinitely are likely to be disappointed, he said.

"There are some local markets, especially in coastal Florida, where I've heard stories for more than a year about behavior that's got to be characterized as nothing other than speculation," Guynn said it response to questions after his speech.

"It makes me very uncomfortable," he added. "Some buyers, some builders, some lenders are going to get burned, could very likely get burned, in some of those local markets."

The entire speech is on the Atlanta Fed website.

Click here for the minutes of the May 3 meeting.

Some highlights:

Partly in response to the receipt of weaker-than-expected data for spending and output in the first quarter, the staff marked down somewhat its forecast of economic growth for 2005 and 2006.

...

In their discussion of current conditions and the economic outlook, meeting participants observed that incoming data over the intermeeting period hinted at possible upside risks for inflation and downside risks for economic growth. Earlier increases in energy prices seemed to be an important factor contributing to an uptick in core inflation and a slower pace of economic activity. With energy prices leveling out more recently, however, and the behavior of compensation suggesting a lack of pressure in labor markets, underlying inflation appeared to remain contained. The weakness in spending was widespread and could not be completely dismissed, but it had appeared only very recently and could be a product of the inherent noisiness of high-frequency economic data. On balance, economic fundamentals including low interest rates, robust underlying productivity growth, and strengthened business balance sheets were expected to support economic growth at a pace sufficient to gradually eliminate remaining slack in resource utilization. Although the economic outlook generally seemed favorable, there was also broad recognition of greater uncertainty attending the outlook for both inflation and output growth.

I'll quote these three paragraphs in full to avoid any chance of taking them out of context.

In the Committee's discussion of monetary policy for the intermeeting period, all members favored raising the target federal funds rate 25 basis points to 3 percent at this meeting. Although downside risks to sustainable growth had become more evident, most members regarded the recent slower growth of economic activity as likely to be transitory. In this regard, the ability of the U.S. economy to withstand significant shocks over recent years buttressed the view that policymakers should not overreact to a comparatively small number of disappointing indicators, especially when economic fundamentals appeared to remain quite supportive of continued solid expansion. To be sure, the Committee had raised its federal funds rate target appreciably over the past year, and, in the view of a few members, a larger-than-expected moderation of aggregate demand in response to this cumulative policy action could not be ruled out. However, all members regarded the stance of policy as accommodative and judged that the current level of short-term rates remained too low to be consistent with sustainable growth and stable prices in the long run. Against the backdrop of the recent uptick in core inflation and in some measures of inflation expectations, members agreed that they should continue along the course of removing policy accommodation at a measured pace conditional on the outlook for inflation and economic growth.

In discussing the statement to be released after the meeting, members agreed that it was appropriate to acknowledge that rising energy prices seemed to have spurred an increase in core measures of inflation by dropping the reference from the March statement indicating that "The rise in energy prices, however, has not notably fed through to core consumer prices." They likewise all agreed that mention should be made that, on balance, longer-term inflation expectations remained well contained. Regarding the risks to sustainable growth and price stability, some members noted that the risk assessment conditioned on "appropriate policy" no longer seemed to convey useful information regarding the Committee's economic and policy outlook. Although some members noted that a case could be made that the risks to inflation were now somewhat skewed to the upside and those to sustainable economic growth perhaps to the downside, the most likely outcome remained one of stable prices and sustainable growth, and the Committee agreed that it should retain a balanced assessment of risks conditional on appropriate policy.

For many, heightened economic uncertainty in the current environment implied greater uncertainty about the range of possible policy outcomes and placed a premium on flexibility in setting policy at upcoming meetings. Some members commented that this greater uncertainty called for eliminating or paring back forward-looking language from the statement--if not at this meeting, then fairly soon. In the event, most members viewed the forward-looking language in the statement--including the characterization of the stance of policy as accommodative as well as the judgment that policy accommodation could be removed at a pace that is "likely to be measured"--as a reasonable characterization of the policy stance and its likely evolution over time. Moreover, a number remarked that the language in its current form was clearly conditioned on economic developments and therefore would not stand in the way of either a pause or a step-up in policy firming depending on events. In the end, all members agreed to retain the forward-looking language.

This is actually quite interesting and informative. First of all, it should put to rest any misinterpretation of "measured pace." It represents the "likely evolution" and "would not stand in the way of either a pause or a step-up in policy firming depending on events."

Then there is the statement that, "some members noted that the risk assessment conditioned on 'appropriate policy' no longer seemed to convey useful information regarding the Committee's economic and policy outlook." There seems to be some increased support for including language that is a bit more frank about the risks to price stability and sustainable growth. Perhaps the next press release will be more blunt. Perhaps this is the line that the committee really wanted us to read (to prepare the way for more direct language in the future). We'll see in a few weeks.

Other than that, there is little in these minutes that we didn't know already. Nontheless, Wall Street wasn't thrilled (Reuters):

The minutes of the Federal Open Market Committee's May meeting showed the Fed's policy makers believed there was "a discernible upcreep" in inflation, wording that was taken as a sign the Fed would continue its campaign of raising interest rates at a "measured" pace of 25 basis points at a time.

Now, don't tell me that Wall Street learned anything it didn't know already about the "measured pace" business. We've been over that before. Whether Wall Street was more distressed by the possibility of inflation showing a "discernible upcreep" or the markdown of the growth forecast is a question I won't try to answer. But then, 20 points on the DJIA isn't exactly a big drop either.

The 10 year bond gained 7/32 which tells us that the bond market didn't find the inflation news too distressing. On other words, the minutes did nothing to solve Greenspan's "conundrum."

All in all, not much is changed.

UPDATE: The New York Times has this to say:

Participants in the Fed meeting were confronted with a barrage of statistics that suggested slowing growth, but the participants indicated that they felt that any slowdown would be transitory and that they should "should not overreact to a comparatively small number of disappointing indicators."

In hindsight, the decision turns out to have been prescient. In the weeks since the meeting, new data has indicated that job creation, consumer spending and exports have been stronger than originally thought.

Indeed, Wall Street economists have been raising their estimates of growth for the first half of the year. On Thursday, the Commerce Department is expected to revise its estimate of growth in the first three months to 3.5 percent or higher, from 3.1 percent.

UPDATE #2: Mark Thoma comments on the minutes.

UPDATE #3: Macroblog has more.

With a tip of the hat to Mark Thoma (Economist's View), I direct you to today's speech by Donald Kohn.

The speech confirms what I've thought for a while. Donald Kohn's perspective makes his speeches very much worth reading. He was secretary of the FOMC for 15 years before becoming a governor (as well as Director of the Division of Monetary Affairs for nearly all of that time). In a sense, he served the equivalent of a full term of a governor as a non-voting staff member. He is in a unique position to speak on these issues because he's seen it from both sides (staff and governor). That makes for a good speech on inflation expectations and inflation forecasting.

The speech was about energy, but the questions generated the media interest. I linked to this same Reuters story in my previous post, but it deserves additional comment.

Greenspan acknowledged that China needs to amend its exchange-rate policies for its own good. In order to maintain the peg without sparking inflation, China must "sterilize" the large amount of reserves it amasses in the process of buying U.S. dollars and issuing yuan-denominated debt.

"The trouble with the sterilization issue is that they're only able to sterilize about half of what they are accumulating," Greenspan said, which has the effect of leaving its financial system awash in cash that can fuel inflation.

Precisely. All that extra cash does make their shaky banking situation seem a little less precarious. Taking away that extra cash would really shake things up and has always been a reason that China has been reluctant to float the yuan. Once inflation begins to pose a greater risk, they will move... perhaps reluctantly. It's not a trouble-free proposition for them. If it was, they would have done it already.

Next question:

"We don't perceive that there is a national bubble but it's hard not to see ... that there are a lot of local bubbles," he said.

The Fed's policy in sharply cutting U.S. interest rates from 2001 to 2004 to 46-year lows -- before initiating a round of rate rises in June last year that continues -- was criticized by some analysts as having sown the seeds for a potential nation-wide bubble as house prices soared.

Since last June, the Fed has lifted its trend-setting federal funds rate from 1 percent to a current 3 percent in search of a hard-to-define "neutral" rate that neither fosters inflation nor crimps expansion.

Greenspan dodged a question about where the neutral rate is, calling it an "amorphous" concept. "Essentially you get down to the point that we will not know it until we're actually there. Maybe we'll miss it -- it's conceivable."

I agree that there are a lot of local bubbles, but I wouldn't call the Peoria market a bubble. As for the "amorphous" neutral rate, that's not a question I'd want to answer if I were him. I don't think I would say that it's coneivable that we'll miss it though. Some things are better left unsaid. (It's not like we don't all have those thoughts in the middle of the night, right?)

UPDATE: Calculated Risk has more quotes via Bloomberg. Lest anyone think I'm being Pollyannaish about the housing situation (which I would call a bubble in many areas of the country), I remind you of this post. So when CR quotes Greenspan:

"... only those who have purchased very recently, purchased just before prices actually literally go down, are going to have problems."

and a commenter on that blog says:

Would very recently be before or after he recommended prospective buyers to use ARMs?

I have to nod in approval. The ARM comment by Greenspan was a mistake.

The Prudent Investor has more as well.

Ok, so this caught my eye today: (Reuters)

WASHINGTON (Reuters) - The Bush administration is considering whether to ask Federal Reserve Chairman Alan Greenspan to stay in office a few months past the end of his Fed board term, which expires on Jan. 31, The Washington Post reported on Wednesday.

The newspaper said the delay would give the White House more time to conduct the search for a successor, which could include corporate leaders.

A quick check of 12 USC 242 reveals:

...Upon the expiration of their terms of office, members of the Board shall continue to serve until their successors are appointed and have qualified. Any person appointed as a member of the Board after August 23, 1935, shall not be eligible for reappointment as such member after he shall have served a full term of fourteen years.

So it is possible that he could stay on if Bush has not appointed a replacement by the end of January (of if the appointee has not been confirmed by that time). I also suppose that he could announce his intention to resign on Jan. 31 even if a replacement hasn't been found. Wouldn't that be an interesting prospect?

Anyway, I am not foolish enough to make book on whether Bush will appoint someone and whether that person will be confirmed by Jan. 31. (Are you watching C-Span2 today?) But if the President is listening, I have a little advice. Appoint a replacement sooner rather than later and make sure he or she can be confirmed without threat of a filibuster. The markets will thank you. Don't play games with Fed chair appointments. Especially on a day like today, this sort of news gives me an uncomfortable feeling.

Greenspan himself recently took the opportunity of a commencement speech to point out that his time at the Fed is coming to an end.

Dean Harker, members of the faculty, Wharton alumni, friends and families and, especially, members of the 2005 graduating class. I have more in common with you graduates than people might think. After all, before long, after my term at the Federal Reserve comes to an end, I too will be looking for a job.

The entire speech to the graduating class at Wharton can be found here.

UPDATE: Mark Thoma turns the mic over to Tim Duy for today's Fed watching post. Looks like he basically agrees with me:

More generally, what does the difficulty of finding names say about the importance of Greenspan? I don’t want to believe that only he can do this job. If the Administration delays his retirement, it suggests that this is true, casting a pall over Greenspan’s eventual successor and diminishing their credibility. Is this how we want to start off the tenure of fresh blood in the Chairman’s seat? I don’t think so. Maybe the blogging community should turn a fresh eye to the question of possible names to replace Greenspan….

Can we all say it together? Appoint a successor sooner rather than later and don't play games with this position.

UPDATE AGAIN: Edward Gramlich announced his intention to resign his post at the Board at the end of August.

Gramlich, Bernanke, Greenspan. Lots of big shoes to fill.

Nothing really new or unexpected. The week ended as it began, but there was a bit of movement during the week in the predictions for October. David points out that the probability of a pause in the rate hikes took an upward turn early in the week. It looks like that was due to a dive in the probability of being at 3.75% (3 more quarter point increases) in October. The probabilities of all the other outcomes went up--a pause (3.25% or 3.5%) or a more aggressive stance (4.0%). Not sure I can explain that either. I can understand the suddent jump in the probability of 4.0% jumping with the employment report. Could it be just a result of thin trading that far out into the future and a sudden lack of interest in 3.75% that pushed everything else up? Who knows. It only lasted a couple days anyway.

Thank you, David, for the updates.

From the NY Times: "Fed Raises Rates but Bobbles Delivery"

The unexpected amending of the Fed's statement just before 4 p.m. caught the bond market by surprise and cost traders some money. As for stocks, the announcement was so close to the end of the session that its impact was muted. But stocks rose in the last few minutes of trading.

I was right about the time. It's pretty apparent in the intra-day charts.

"I can't remember anything like this," said Louis Crandall, chief economist at Wrightson ICAP. He said one reason the market was caught off balance was that the original statement was the kind of negative news many bond traders had prepared for.

Yes, and prepared quite well. (Hence, the title of the post I wanted to make--"Bond market keeps its head."

The head trader on the Treasury desk at a major bank, who spoke on the condition he not be identified, said, "I can tell you it cost us some money."

When the original statement was released at 2:15 p.m., the price of the Treasury's 10-year note fell immediately but modestly. The yield, which moves in the opposite direction, rose to 4.21 percent from 4.19 percent.

Yes, "modestly" is a good word to describe it. But then...

After the announcement of the restoration, the yield fell quickly to 4.15 percent and the price jumped. In late trading, the yield was at 4.16 percent.

"I think people took positions on a set of facts that they thought to be correct and then they changed," the trader said. For a few minutes, he said, it was hard to buy Treasury securities to cover losing positions, and traders who were short in their holdings had to buy back Treasuries quickly to avoid losses.

I wonder if the volatility will carry over into tomorrow or if traders were able to re-establish their positions. Sound like it was a pretty crazy few minutes in the bond pit. Not what the Fed wants. Not at all.

Now, if that sentence had just been in there in the first place, would there have just been a modest move upward? I tend to think so. Perhaps that's where we'll end up tomorrow (absent any new information pushing us in another direction), maybe 4.17% or 4.18%, which is just barely changed from where we started.

What a day.

UPDATE: Dave Altig does his usual yeoman's work in summarizing the blogs. Check out the links. Some are harsh. Can't say I blame them. I realize we all make mistakes, and I know I've made my share. But when the stakes are this high, you really need to proofread the document to make sure it says exactly what you want it to say. I don't think it will cost them many confidence points, and I sure hope it doesn't. But still...

Yes, I thought it was a little odd that the statement that came out at 2:15 EDT lacked a sentence about long term inflation being contained. I thought maybe they were trying to sound like they were playing to both sides. There was a mention of the slowing economy but also a tacit acknowledgement of creeping inflation. This was followed by a conditional outlook. A whiff of stagflation? It was a question worth pondering. I started to see headlines on the 'net that stocks were falling on the news. Bonds appeared to hold steady. I began composing a post in my head that I would call "Bond market keeps its head."

And then, this. In the first ever "oops!" of this kind, the FOMC corrects itself saying it left out the sentence about long-term inflation being well contained.

I don't know exactly when the announcement of the corrected press release came in (anyone?), but I looked at the intra-day 10 year yield and I'm guessing it was close to 4pm EDT. As of now, the bond is up 6 ticks and the yield is at 4.16%. I'm thinking it might still give a little of that back--it was up 8/32 for a while. Interesting little episode, but I don't think there's much to make of it other than illustrating to our students just how tightly wound the bond market is right now.

The press release wasn't bad to begin with, and adding back that sentence (which has been there before) makes it marginally better. I'm definitely not as bewildered by the bond market as I was in March. The 10 year might be a little overvalued for my blood, but at least they didn't react the way they did last time. For the most part, the market did keep it's head today in a collective sense.

And I think that this statement keeps the door open to a faster or slower pace of monetary adjustment as needed. If you've been watching the intermeeting data, nothing in this statement should surprise you. The acknowledgement of the "soft patch" comes here:

Recent data suggest that the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices. Labor market conditions, however, apparently continue to improve gradually.

Special note to my intermediate macro students: This language is pretty close to what we discussed this morning.

Oh, I should mention that today is the last day of classes at Bradley University before finals start. As I have done for the last couple years, I led my intermediate macro class in a simulated FOMC meeting on the last day of class that coincides with an actual meeting day. When it also happens to be a the last day of class, it's a great way to end the semester.

They did a fantastic job.

Note to macro professors: For a good description of an FOMC simulation, see this paper by Scott Simkins. If you actually try to do the simulation it would be worth reading A Term at the Fed by Laurence Meyer for a detailed description of what goes on in a meeting.

And so now all eyes turn toward Friday and the April employment report.

A 25 basis point increase in the funds rate is all but a certainty. The question is what will happen next. Consider this from the Wall St. Journal (subscription)

About a month ago traders were talking about how, with the U.S. economy strong and inflation picking up, the Fed might raise the rate used by banks on overnight loans by half a point by the time the summer was up. Now that it has become clear that the economy began rowing against the tide in March, the talk is how the Fed might skip raising rates at one of its meetings to assure itself that nothing has gone seriously amiss.

The article finishes with a mention of the yield curve, which is flattening. Speculation is increasing that a pause in the rate hikes is coming. (See macroblog's weekly installment on the fed funds futures.)

It's no secret that everyone will be parsing the press release for words indicating that a pause is around the corner. I'm thinking that we will see a press release that looks a lot like the last one. The biggest thing that the FOMC could realistically do tomorrow is to change the risk assessment. I don't think they will, but that would open the door for a pause.

One thing they should not do, however, is allow inflation expectations to creep up--even if that means continuing the rate increases at a... (*cough*)... "measured"... pace.

Via Mark Thoma--read here for the whole speech:

But, in the same vein, we should not hesitate to raise interest rates to contain inflation pressures just because it might set off a retrenchment in housing prices, just as we were willing to keep rates unusually low as house prices rose rapidly. Nor should we hesitate to raise rates because higher rates mean higher debt-servicing burdens for the current account, the fiscal authority, or households. In my view, our role is to anticipate as best we can the macroeconomic effects of imbalances and their correction and to respond to unexpected changes in asset prices and spending propensities as they occur. It is through such actions that we aim to achieve our objective of economic stability.

Compare to Sandra Pianalto's comments I reported on yesterday.

A while back I wondered out loud if some folks in the bond market were doubting the Fed's inflation fighting resolve. I'm sleeping better now. The speeches by Fed officials towards the end of the week were probably good words to get on the record.

Given all the talk about soft landings as well as Greenspan's dire warning on the deficit today, I thought this would be a good way to sum up my thoughts at the moment.

Thanks to David Altig for the link. He has some more extensive quotes at his blog. The whole speech by Cleveland Fed President Sandra Pianalto is worth reading, but this really fits my mood concerning the day's discussion.

In the long run, a central bank cannot balance the government's budget, boost national saving, create more energy resources, or solve the many economic problems that we must confront. But a credible monetary policy will help smooth the adjustment to economic circumstances that come our way.

Precisely. Full stop.

WASHINGTON (Reuters) - Federal Reserve Chairman Alan Greenspan warned on Thursday that unless lawmakers come to grips with spiraling U.S. deficits, the economy was at risk of stagnation "or worse."

"Under existing tax rates and reasonable assumptions about other spending ... projections make clear that the federal budget is on an unsustainable path, in which large deficits result in rising interest rates and ever-growing interest payments that augment deficits in future years," Greenspan told the Senate Budget Committee.

He said that while the U.S. economy was "doing well," the danger was that deficits would keep rising as a percentage of total national output.

"Unless that trend is reversed, at some point these deficits would cause the economy to stagnate or worse."

Greenspan's complete prepared remarks are on the Fed's web site. Have at it!

PGL examines Bruce Bartlett.

While I agree with his concern, I don’t agree with Bruce’s analogy to the FED tightening during 1999-2000 for two reasons. One is simply that labor markets were tight five years ago and they are not currently. The second reason goes to the discussion at the end of Bruce’s op-ed – that being the “twin deficits” issue. The better analogy would be to compare the current situation to that during 1981 when labor markets were not tight but the FED was concerned with excessive long-term fiscal stimulus.

Absolutely correct on the first part.

On the second part, I differ a bit. 1981 might not be the best comparison either. While the point about the labor market is correct, the current account was in surplus in 1981. The budget was in deficit. In 1999 and 2000, the opposite was true. Today, both are in deficit. That's a pretty big difference right there.

Another difference is that in 1981 the Fed spiked the real funds rate up to almost 10% to wring the last vestiges of the 1970s inflation out of the economy. I really don't see that being in the cards.

I think 1994-95 is a better analogy. (I know, I know, you're not surprised, are you?) The twin deficits had reasserted themselves briefly. The labor market certainly was not tight--unemployment rates were comparable to today's. Employment growth was returning to normal after a jobless recovery (it's unclear that employment growth in the present environment is quite back to normal--it seems to be taking a little longer this time). The strike against inflation by the Fed was preemptive, rather than closing the barn door after the cows got out.

One difference was that tax receipts were trending upwards in prior years (thanks to George H.W. Bush). This has not been the case in the last few years. However, that picture is starting to turn around--not fast enough for some, but turning around nonetheless.

POSTSCRIPT: I forgot to point out that Bartlett finishes his column with:

Hopefully, this can all be managed smoothly and without either a recession or a market break. But it will take great skill and a lot of luck to avoid both.

I couldn't agree more.

UPDATE: PGL and Bartlett spar in the comments at Angry Bear. Worth reading.

Enjoy it while you can. The next FOMC meeting is on May 3, two weeks from today. Fed officials observe a "blackout period" beginning one week in advance of the meeting and extending to the Friday after the meeting. You'll probably hear a number of FOMC members get their licks in before next Tuesday.

Today, it was Janet Yellen and William Poole.

San Francisco Fed President Janet Yellen said high energy prices may have created a soft patch by crimping consumer spending, while St. Louis Fed President William Poole said the economy is forging ahead and promises sustained growth.

Interviewed on CNBC, Yellen said "we're hitting something similar" to the conditions seen in the second quarter of 2004, when the pace of economic growth waned.

"We've had some recent readings on trade and retail sales that suggest maybe we had a soft spot in March," Yellen said. High energy prices "draw purchasing power away from a broad range of other goods and services."

Even so, the economy is still growing modestly above its long-term trend pace of 3.25 percent to 3.5 percent, "just enough to reduce labor market slack over time," she said.

Yellen, who leads the largest Federal Reserve district, was the first Fed official to address weak economic data that has jolted market expectations for Fed policy over the past few weeks.

Rate futures dealers, fearful of slower growth, see a chance that the Fed will pause its program of 25 basis point interest rate hikes as soon as August.

The Labor Department on Tuesday said March's core PPI rose 0.1 percent, below Wall Street forecasts. Headline prices jumped 0.7 percent, the biggest advance since October, as gasoline and heating oil prices jumped.

Poole and Yellen. both non-voters on the Federal Open Market Committee this year, said rising headline inflation recently showed a "pass-through" of energy prices but that long-term inflation prospects were sound.

"The outlook for inflation looks quite or very favorable," Poole told reporters after a speech on entrepreneurship. Tame labor costs and growing productivity were helping to keep a lid on inflation, he said.

Yellen said the energy price hikes would most likely also appear in indicators such as the consumer price index, due for release on Wednesday.

All in all, a very fair and even-handed assessment. And yes, tune in tomorrow for the CPI.

By the way, Mark Thoma has a post to St. Louis Fed President Poole's remarks.

"As we get into that (normal) range, policy will become increasingly data dependent," Poole said.

"Last year is the unusual period and you should not expect that as a pattern going forward ... Last year was the exception to normal practice," he said, referring to the predictability of Fed rate hikes after the central bank vowed to remove its policy accommodation "at a pace that was likely to be measured."

Flashback 1994-95: After a few 25 b.p. hikes, the FOMC alternated between doing nothing and raising the funds rate by 50 b.p. or more. In other words, the first few were pretty predictable. The next few, not so much.

I don't see any 50 b.p. increases around the corner, but alternating between doing nothing and 25 b.p. increases is not out of the question.

This assurance was repeated at the last Fed meeting, on March 22, but Fed-watchers expect it to drop the language in the months ahead.

Poole declined to speak directly to the issue of the language in the Fed's interest rate statement but made clear that he felt that all options were open.

As I reported previously, Poole elaborates on this point here.

Spelling it out, Poole said Fed rates could either rise, fall or stay the same, adding: "I want to be quite symmetrical about that" to emphasis that he was giving no more weight to one outcome than either of the others.

That is an interesting way to finish. Personally, I can't see a decrease (see above), but he might be preparing us for the possibility of it later in the summer or even fall.

Mark Thoma's take:

Thus the message is, beginning with the next FOMC meeting, not to expect a straight line path to the target Federal Funds rate.

My take, using my aviation analogy:

We're transitioning from the approach phase to the landing phase. The workload on the pilot just doubled. Fasten your seat belts.

In textbook terms, real GDP is approaching potential GDP from below. Overshooting will cause inflation and too much tightening will kill off the expansion prematurely. Rate movements are going to be very data dependent, much like the 94-95 soft landing. Prediction gets harder. Uncertainty abounds. People hang on every word of every news release, looking for something that will give them a clue of what will happen next. (It's the CPI tomorrow.)

I remember it well from 94-95. I was a first year grad student at the time and following this intensely. While some things are different, I notice a lot of similarities.

And people wonder why I find this stuff fascinating. How can anyone not be fascinated by it?

This time a hard landing of stagflation. A few days ago, he pondered a hard landing caused by a dollar crisis.

So many things to go wrong. In a dollar crisis, interest rates would spike, and that would be a contributing factor in slowing the economy. In stagflation, inflation takes off at the same time unemployment rises and the Fed must decide if it will raise or lower real interest rates (nominal rates will be rising due to inflation). Could a dollar crisis touch off a bout of stagflation? Yes, it could.

Mark plans to write more about hard landings in the coming days. That's good. It's worthy of discussion. I'll throw in my 2 cents from time-to-time.

I don't think I've defined what I think of as a hard/soft landing yet, so here goes.

I am a licensed (but currently inactive) pilot. I have been at the controls of a single engine airplane for many landings, some hard and some soft. Let me tell you, it's every pilot's goal to make the perfect "soft" landing--the one where you don't even feel the wheels touchdown. It's rare, and it takes a lot of skill just to have a chance at a soft landing.

When a new pilot makes a hard landing, it's usually because he or she thought the runway was about a foot higher than it really was. The pilot did a nice job of essentially landing the plane in the air a dozen inches off the surface. The airplane, not knowing any better, figured that its job was done and stopped flying... and began a brief one foot free-fall. Coffee gets spilled, but no lives are lost. Do it a few more feet up an you might bend the landing gear. Do it a hundred feet up and you might not live to tell about it.

Another kind of hard landing is coming in too fast and slamming into the ground. Use your imagination. New pilots do this once in a while too. As long as you correct for it before you hit the runway, you might save the upholstery, but probably not your pride as the folks in the hangar watch you float half a mile down the runway.

Last but not least is the hard landing that just happens. Everything is perfect and then the wind changes. It's like someone suddenly dropped you towards the ground. Been there. It stinks.

What's my point? I remember when the term soft landing started to be used to describe what the Fed did in 1994-95. I liked the term because it seemed to describe in familiar aviation style terms what was happening. The changes in interest rates in 1994-95 were like the corrections that a pilot makes when coming in to land. Too much too soon and you land above the runway and free-fall (choking off the expansion). Too little too late and you either slam into the ground or float half a mile (runaway inflation). Of course, you could do everything right and still spill your coffee when the wind changes at the last minute (oil price spikes).

When things change at the last minute, things can indeed get dicey for both pilots and central bankers. You don't want to use all of your ability to control the situation until you really are safe on the ground. That is Mark's point, and it is a correct one--for pilots and central bankers.

Greenspan did a lot of things right in 94-95, and got lucky besides. The wind didn't shift suddenly on us then, unless you count the Peso crisis, which did make things touch-and-go for a while (aviation pun intended) but was ultimately not much of a factor (for the U.S.) in the soft landing that followed. We had plenty of policy ammunition left to deal with it.

A soft landing is stable inflation and unemployment at sustainable levels in the maturing phase of an expansion. You'll know it when you feel it (or don't feel it, as the case may be).

This story will continue for a while. I imagine Mark and I will be commenting periodically on this until we... uh, land.

It's Monday. You know what that means!

Notice that the probability of a pause in rate hikes in July has taken a turn. We'll have to watch and see where that goes.

This is the second in what I am planning as a series of installments on the similarities (and differences) between this point in the recovery and the corresponding point in the last cycle, about 1994/95. Astute readers will remember that the Fed commenced with an extended period of interest rate hikes beginning in February 1994 and continuing for a little over a year and ending with what was widely regarded as a "soft landing." We seem to be in the middle of that sort of situation again. The end of the story (the softness of the landing) has yet to be written.

The graph above shows the major currency index immediately before and during the tightening period. Now, I've been thinking about this topic for a while and have long suspected that there are similarities (though I do intend to point out differences as well) between this cycle and the last. I was expecting the two series to be similar, but I wasn't expecting this close of a match. It looks like the only real difference was a steeper depreciation of the dollar in the months leading up to the start of the rate increases. One could perhaps say that this suggests that the Fed started tightening a little late, at least where the dollar is concerned. However, I don't subscribe to that. The Fed's credibility has increased considerably since 1994 and the fact that the dollar appears to have responded in like manner once the tightening began is, I think, evidence that the policy is working. In 1995, the dollar bottomed out about 15 months after the start of the rate hikes. In the current context, that would correspond to about the first of October of this year.

To be sure, there is no guarantee that the current cycle will proceed along the same lines. Indeed, a multitude of factors, foreign and domestic, could push things off course. Let's not forget that there were currency interventions in the 1994-95 period, though it is not entirely clear that all of them were effectual.

So let's just say this is interesting. I will, of course, update the chart as necessary.

A quote from the minutes:

They also noted that the language had not precluded a notable increase in medium- and longer-term interest rates over the intermeeting period as markets extended the expected gradual increase in policy rates.

On the release of the minutes, the 10 year yield shed about 8 basis points almost immediately.

So what does all this mean? In a way, it looks like it's back to business as usual, but perhaps with a bit more clarity as we go forward to the next meeting. But let's go back to March 23, when I said:

If you haven't guessed by now, the thing that still puzzles me the most about Tuesday's events is why the bond market reacted so suddenly, so negatively to news that was not really news. What motivated traders to hold on to the 10-year until 2:15pm EST yesterday? If "measured" isn't that significant, and if the Fed is committed to keeping inflation at bay, and if we all knew that price pressures are building based on previous information, why did they wait for the statement to move?

Truth be told, the bond market did make it back to where it was right before the meeting within a few days. At the close today, the 10 year yield is down to the level of early March, around 4.35%. The 10 year, at least, has gained back all of what was lost on March 22nd and then some (which adds to the irony of my opening comment). I feel vindicated. I think I was right to be puzzled.

In the end, I think that the release of the minutes today did a lot of good. It brings some clarity to the situation. Some of the FOMC members were concerned, as the minutes confirm, about the continued use of the term "measured pace." But given the latest employment data and the general economic picture right now, those words might be with us for another few weeks--or at least until they can come up with something better.

At the close of the market today, the market feels like inflation really is contained, but some pressures are there. And if employment costs start to rise or other price pressures emerge, the Fed will act quickly, perhaps even with a 50 b.p. hike--but only if necessary. No need to dump those bonds yet.

And so, at the end of the day, 10 year yields are at the levels they were in early March, well ahead of the last FOMC meeting. The yield curve is flattening again.

Greenspan's "conundrum" is back. This story isn't over yet.

Along those lines, here's a CNN article that suggests the bond market might be in denial.

Thoughts?

The minutes of the March meeting are out. As is often the case, the really good stuff is towards the end. Here are some highlights.

Meeting participants commented in particular detail on the inflation situation. They noted with some concern the recent elevated readings on inflation in prices of core personal consumption expenditures, the producer price index, and indicators of prices at earlier stages of production, as well as the sizable further increase in energy prices. Nonetheless, many participants stated that they expected total inflation to diminish and any rise in core consumer inflation to be limited. One source of upward pressure on inflation had been the rise in energy prices, and it seemed reasonable to expect that these prices would level out or even decline mildly, as built into futures prices. Unit labor costs were still being held down by moderate wage growth and rising productivity. Indeed, a few saw a distinct possibility of further positive productivity surprises, representing a downside risk to the inflation outlook. Moreover, the markup of prices over costs in nonfarm businesses remained quite high, and firms would likely be pressed by competition to absorb a portion of any step-up in the growth of unit labor costs, at least if that acceleration were limited in extent and duration. In addition, prices of many non-energy commodities had risen in recent weeks, but such inputs constituted a relatively small fraction of overall business costs, and, partly for that reason, in the past commodity prices had demonstrated little predictive content for broad inflation rates. While short-term inflation expectations had risen somewhat, longer-term inflation expectations remained well contained. And lastly, monetary policy would be aimed at preserving price stability.

Still, many participants indicated that their uncertainty about the intensity of inflation pressures had risen in response to recent developments and that, in particular, the distribution of possible inflation outcomes was now tilted a little to the upside. Although monthly statistical releases could be quite volatile, the recent data showing consumer inflation a little above previous expectations were of concern. Also, anecdotal indications of price increases were becoming more common across a number of industries. Some business executives reportedly believed that, with aggregate demand expanding robustly and the lower foreign exchange value of the dollar putting upward pressure on import prices, a degree of "pricing power" had returned. Moreover, the recent rebound in spot crude oil prices, and especially the substantial advance in prices of crude oil futures contracts for delivery well into the future, suggested that a significant unwinding of higher energy costs might not be in prospect. Several participants indicated that, in current circumstances, they viewed an upside surprise to inflation as potentially more harmful than an equivalent downside surprise, partly because such an outcome could well impart additional upward momentum to inflation expectations.

This passage is interesting...

... Although the required amount of cumulative tightening may have increased, members noted that an accelerated pace of policy tightening did not appear necessary at this time, as a degree of economic slack apparently remained, productivity growth would probably continue to damp increases in unit labor costs and prices, and inflation would most likely continue to be contained. In these circumstances, Committee members judged that the measured removal of policy accommodation was appropriate for now.

... Regarding the risks to sustainable growth and price stability, members discussed a proposal to make the Committee's assessment explicitly conditional on an assumption of appropriate monetary policy so as to underscore that maintaining balanced risks would require policy action. It was noted that the Committee's assessment of balanced risks over the past nine months--a period in which monetary policy had been steadily tightened--necessarily had to be interpreted as based implicitly on an assumption that policy accommodation would be removed. A number of members believed that formulaic language by its nature was too rigid to reflect evolving economic circumstances in a satisfactory manner, especially when developments were subtle or complex, and some of these members believed that the risk assessment should be discontinued. All the members ultimately approved making the risk assessment in the policy announcement following this meeting explicitly conditional on appropriate policy.

And finally, the part I was really waiting for...

Members also focused on the issue of whether to reiterate the judgment expressed in the Committee's recent statements that ". . . policy accommodation can be removed at a pace that is likely to be measured." Some expressed the view that such language could constrain future policy inappropriately; while these concerns were not new, they were now felt to be more pressing, as the odds that the Committee might need to step up the pace of policy firming were thought to have increased. Members noted, however, that the existing "measured pace" language was clearly conditional on the economy evolving in a way that promised a gradual return to high levels of resource utilization and on inflation remaining low, and thus believed that the wording did not rule out either picking up the pace of firming or pausing in the process of removing policy accommodation should circumstances warrant. They also noted that the language had not precluded a notable increase in medium- and longer-term interest rates over the intermeeting period as markets extended the expected gradual increase in policy rates. Some discomfort was expressed with language that related so explicitly to the likely trajectory of future policy action. But it was also averred that the Committee should, to the extent possible, provide information that would help the public anticipate the probable course of monetary policy; providing such information would tend to increase the effectiveness of monetary policy. More generally, members recognized that the Committee's statement would need to evolve over time. (Emphasis mine.)

"Measured pace" does not mean 1/4 point increments. I think that much is clear. And I don't need to tell you that I'm glad about that. I was beginning to hate those words because I too think they are too constraining. I think the market misinterpreted them for a while, but we should be past that by now.

I have to go teach. More later.

Ben Bernanke is speaking in St. Louis on Thursday at the annual Homer Jones lecture.

If only it were on Friday. On the bright side, I'm sure the text of the speech will be posted on the internet.

Dave Altig knows what we want. He says that he'll be posting charts showing the implied probability of various outcomes for the fed funds rate as a regular feature every Monday.

Concerning today's charts, he says

The clear message in the latest data is the return of the "measured pace" expectations following the weaker than expected March employment report.

If "measured pace" means 25 basis points per meeting, that is.

Keep those charts coming!

Via Reuters:

Speaking in Washington, [Philadelphia Fed President Anthony] Santomero said policy-makers can move in a "slow and cautious manner" but cannot afford to get "behind the curve."

"We think he meant this in a more general sense, but the market may be reading it as a comment that is reflective of current circumstances," said Alan Ruskin, research director at 4CAST Ltd.

In the past week the bond market has largely discounted potential for the Fed to boost the pace of its interest rate increases.

Rate futures price a 25 basis point increase at the May 3 Federal Open Market Committee meeting, but chances of a 50 basis point hike are just 13 percent.

Santomero told reporters after the speech that the data "is consistent with inflation being reasonably well-contained," but that anecdotes suggest increased price pressure. "I think inflation is worth watching," he added.

So, we can be "slow and cautious" but can't "get behind the curve." Data suggests that inflation is "reasonably well contained," but it's also "worth watching."

This is interesting. I think most people are expecting the Fed to have to get more aggressive sometime, but we don't know when. Words like these seem to increase the uncertainty. This is the new way to "jawbone" long term rates up, and it appears to be working.

Like inflation itself, this development is also worth watching.

UPDATE: St. Louis Fed President William Poole is less ambiguous.

"The upward thrust to the economy appears quite substantial and the risk of higher inflation over the next six months or so seems clearly greater than the risk that inflation will fall below a desirable range," said Federal Reserve Bank of St. Louis President William Poole.

He continues,

"I think the FOMC (Federal Open Market Committee) could improve clarity, especially when policy direction changes, by agreeing in advance on stock phrases to describe different situations," he said.

I think what Poole is trying to say is that "measured pace" is too brief, uninformative, and ambiguous. We can do better at describing a set of contingent paths the Fed might take. He elaborates in his speech.

This excellent speech by Ben Bernanke should be read by every macroeconomics student. I think it is good that Fed governors actually get out there in the public and make speeches like this once in a while.

Here's a sample.

The person in the street might tell you that the Fed "controls interest rates." That statement is not literally accurate. In fact, the Fed has little or no direct influence over the interest rates that matter most for the economy, such as mortgage rates, corporate bond rates, or the rates on Treasury securities. Instead, the Fed affects these key rates, as well as the prices of financial assets such as stocks, only indirectly.

Thanks to macroblog for the link.

Click the image to enlarge it and make it a lot clearer. I'm still trying to perfect the art of blogging charts. I need to create a good template and use it.

I wanted to post this earlier, but I've been under the weather for a few days, hence no posts for the last couple days.

Anyway, I am going to do a series of occasional posts for the next few weeks on the similarity of the fed funds easing/tightening cycles in the early 1990s and the early 2000s. The rise at the end of the chart (blue line) takes us into early 1995--the last real tightening that produced not a recession, but a "soft landing." In fact, I think the term "soft landing" was first applied to Fed tightening in the 1994-95 episode. As you can see here, the dollar was also at a low point in 1995. Yet, 1995 was the beginning of a pretty good number of years. As I recall, there was also a bit of a movement to fix Social Security that started about that time. What else is the same, and what has changed since 1995.

In no way do I mean to suggest that past performance is suggestive of future results. Please don't take that away from this observation. It is just that, an observation. I do, however, think there are some striking similarities as well as differences. I should also point out that the heady days of the mid-1990s in which money flowed like crazy into emerging markets led to the Asian financial crisis in 1998. I should also point out that in late 1994, the Mexican peso collapsed, causing much alarm.

No, 1994 and 1995 weren't perfect. But they were years in which a number of forces came together for better or for worse to shape the last half of the decade. Whether the reason things worked out the way they did was because we were good or because we were lucky is still up for discussion. But the last half of this decade could similarly depend on the decisions we make this year.

Expect occasional posts on this from time to time. Reader comments and observations are welcome.

But now I must get some rest.

King Banaian at SCSU Scholars posts a graph from Chart of the Day that you really should see.

Elsewhere in the roundup, Brad Setser asks the 1.3 billion dollar question, and The Eclectic Econoclast mirrors my optimism.

None. That is, as I write, there is almost no movement in the 10 year since yesterday's close. Indeed, at the moment, it has gained back a little bit of what it lost. Those who were expecting more bloodletting in the event of inflationary news might have been surprised. I was not expecting a huge sell-off, even with the 0.4% increase in the CPI. Yesterday's activity seemed like enough movement to price in the increased inflation expectations. I still think it a little strange that the jump in the 10 year yield waited until after the FOMC statement when there really wasn't a lot of new information in the statement. Then today when the CPI comes out higher than expected (I read that the expectation was for 0.3%), there is almost no movement.

Now, normally, when inflation begins to peek through the data it makes a splash in the bond market. That there was no additional reaction today would seem to suggest that even today's somewhat higher than predicted inflation was already priced in to some extent.

For some time, it seemed like the 10 year yield was "too low" and that was a puzzle. As David Altig at macroblog points out (citing Steve Leisman), maybe that's because the Fed was getting too predictable. For his part, however, Altig does not really put much stock in that problem, as he writes,

I'm not sure if this new language combined by with the old language solves the Leisman problem or not, because I didn't really understand the problem in the first place.

Nor did I. That is, I didn't feel that this is a problem for my own interpretation. But I clearly do think that the bond market was, at least to a point, thinking in those terms. My comments leading up to and immediately after the FOMC statement sort of give that away. Even if Altig and I don't happen to worry about such distinctions, bond traders might and so we ignore those distinctions at our peril.

And so I do think that the language of the statement does solve (or at least address) the Leisman problem, if you want to cast it in those terms. If, as has been suggested, bond traders were finding the Fed too predictable and were "undoing" Fed policy by undertaking leveraged carry trades, that bubble popped yesterday. I predict that there will be a slight premium on the bond yields as that uncertainty over when the more aggresive stance will translate to policy action heightens the market's sensitivity to inflation in weeks to come.

In light of this, it seems that what really was eating at the bond market yesterday was not so much a perceived lack of aggressiveness against inflation as much as a frustration with the increased uncertainty over how and when that commitment will translate to actual policy changes. As someone who favors greater central bank transparency, I'm not so sure I like that. I really hope it doesn't signal any weakening of the commitment to fight inflation. I don't think it will, but the proof is in the pudding.

Meanwhile the dollar continues to gain, which reassures me that the market isn't discounting the Fed's credibility.

Fed funds futures charts at macroblog. Right now the market looks to be saying the probability of a 50 b.p. increase in July is becoming increasingly likely. Unfortunately, I think this might rekindle some of the frenzy over the word "measured" leading into the May meeting. Time will tell.

Update: More on inflation (charts) at Angry Bear

Update: John Berry at Bloomberg has this to say:

First, it was responsive to a growing concern in financial markets that inflation pressures have worsened. Thus, even if officials aren't as concerned as some private economists -- and many aren't -- as a group they have said, "We are on the case."

My point yesterday was to ask whether that is enough. I hope it is, but it's a legitimate question.

Second, if incoming data confirm that inflation indeed is getting worse, the market has been warned that rates may be headed higher more quickly.

Yes.

Third, the door is open to removing the "measured pace" language which some officials have objected to from the beginning on the grounds that it is too predictive of where policy is headed. Whether that phrase actually will disappear in May is uncertain.

Proof that in spite of the incredible strides that Greenspan and Co. have made towards increasing transparency, it's not a perfect science.

The exchange market, for one, is not.

The changes in the statement raised the prospect of the Fed accelerating its current steady rate rises.

"It really raises the possibility of a 50 basis point hike down the road or higher rates than was previously thought," said Marshall Gittler, senior market strategist at Deutsche Securities in Tokyo.

It's looking like "measured" refers to the expectation, but the risk is higher. If things go sour, "measured" goes out the window--fast! I'm willing to go with that interpretation if the markets are. I think it's a better interpretation than the market had 24 hours ago. I'll sleep easier now.

The dollar was up, but...

High-yielding currencies that investors have favored in carry trades also took a bruising.

Ah... that would explain some of what's going on.

For more on carry trades, see this excellent post at macroblog.

Finally, we have this,

While the threat of faster inflation is usually bad for a currency, the Fed's promise to stamp out price pressures with higher rates helps lure foreign investors to short-term dollar deposits. Treasury bond yields at eight-month highs may also entice investors.

Right, and the market was more sanguine about this than I thought they would be. That's a good thing. Nice to be pleasantly surprised.

If you haven't guessed by now, the thing that still puzzles me the most about Tuesday's events is why the bond market reacted so suddenly, so negatively to news that was not really news. What motivated traders to hold on to the 10-year until 2:15pm EST yesterday? If "measured" isn't that significant, and if the Fed is committed to keeping inflation at bay, and if we all knew that price pressures are building based on previous information, why did they wait for the statement to move?

Maybe all those leveraged carry trades started to unwind all of a sudden. Maybe the exchange market was more forward looking today than the bond market.

Maybe.

One thing I know for certain... it was a fascinating day in the financial markets. This is what I live for as an economist. What will the morning bring?

In a nutshell here's what's been bugging me about the wording of the press release today and the media and market response to it.

People are treating this as if the Fed's stance in this press release is aggressive towards inflation and as if that aggressiveness and the warning of inflation is the reason for the bond market taking a dive.

I see in that press release the word "contained" twice as it relates to inflation. I see only one mention of inflation pressure picking up. I see the word "measured," which suggests to me that the rate increases will be 25 b.p. at a time. I see them say, "the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal."

There's not much in there for inflation hawks, despite what everyone is saying. I think that is what the bond market is worried about. If the word "measured" had gone, then perhaps the hawkish ones would take comfort in the fact that a 50 b.p. increase is coming. (Note: I am not advocating a 50 b.p. increase at this time, I'm just trying to understand market sentiment. And clearly there are a significant number of market participants who expect and/or want 50 b.p. sometime before the end of summer.)

I don't see a 50 b.p. increase in the cards for the next meeting. Up to very recently, some did. That's what I think has the bond market reeling. Some in the bond market are perhaps a bit disappointed that we will have to continue hearing the word "measured" for another six weeks and a more aggressive rate hike is pushed further in the future.

Otherwise, is there really any information in that press release that we didn't already know? Why should this have caused such a sudden spike in the 10 year yield? Anyone who read the last meeting's minutes knows that firms are more able to pass on price increases to the customer. That's all the press release said.

No, I think the bond market fears that the Fed is risking falling behind the curve and that they are waiting until inflation appears rather than being proactive. Being "measured" is not being proactive. I think this was a failure to meet expectations.

We might know more in the morning when the CPI is released.

Let's start here. The headline is "Stocks, Bonds Fall, Dollar Firms."

How often does that happen? The article reads...

NEW YORK (Reuters) - U.S. stocks and bonds fell and the dollar firmed on Tuesday after the Federal Reserve said inflation picked up recently, indicating to traders that the pace of interest-rate hikes could quicken in the months ahead.

As expected, the Fed raised rates by a quarter-point for the seventh straight time and maintained its "measured pace" language regarding future increases.

But what got investors' attention in the Fed's accompanying statement was that pricing power was increasing in the world's biggest economy.

Stocks reversed course and went negative.

The Dow Jones industrial average was down 45 points, or 0.43 percent, at 10,520. The Standard & Poor's 500 Index was down 5 points, or 0.46 percent, at 1,178. The Nasdaq Composite Index was down 10 points, or 0.50 percent, at 1,998.

"The Federal Reserve said it was going to continue raising rates at a measured pace while acknowledging that inflation is starting to edge higher," said Michael Sheldon, chief market strategist at New York brokerage Spencer Clarke.

"The reason the stock market gave up its gains following the Fed meeting is because some investors are seeing through the Fed's gentle phrasing and are realizing that the Fed is starting to become more serious about fighting inflation."

Tell that to the bond market...

The yield on the benchmark U.S. Treasury 10-year note rose to its highest level in eight months.

"Instead of dropping 'measured,' they chose language that acknowledges the modest pickup in inflation pressures," said William Fitzgerald, head of fixed-income portfolio investment at Nuveen. "This may be a step toward getting rid of 'measured,' of being more aggressive without indicating a change in the plan."

Remember what I said yesterday about the word "measured" taking on a life of its own? Apparently now we need to take gradual steps to remove that word. And "being more aggressive without indicating a change in the plan"? That's the kind of answer you give when you've just been blindsided.

The yields on the 10-year Treasury note shot up as high as 4.62 percent from 4.48 percent just before the Fed release and 4.52 percent late on Monday. The yield on the two-year note rose to 3.75 percent from 3.72 percent.

So you're trying to tell me that stocks fell because the Fed is going to get tough on inflaton, and bonds fell because the Fed is not being tough enough on inflation. The choice of words managed to give everyone something to complain about. Leaving in the word "measured" while acknowledging inflation was not what people wanted to hear.

So how about some good news?

The euro initially slipped half a cent to session lows around $1.3146, according to Reuters data, from around $1.3200 shortly before the Fed announcement, and down about 0.2 percent from levels late on Monday in New York.

Against the yen, the dollar rose to 105.23 yen, up from around 105.07 yen shortly before the announcement.

What gives? CNN thinks it knows...

Higher rates makes U.S. securities more attractive to foreign investors, who must purchase the notes in U.S. currency.

The dollar has gained more than 2 percent against the euro and yen since the start of the year as investors bet that rising interest rates and higher yields on dollar assets might help offset worries about structural problems in the U.S. economy, including the nation's massive deficits.

I dunno... it didn't look like foreign investors were scrambling for dollars so they could rush out and buy stocks and bonds this afternoon. It would seem more likely to me that the exchange market is just reserving judgement and waiting until tomorrow's CPI data comes out. The CPI data will either be a reassurance to the bond market or the other shoe dropping on bonds and the dollar. I guess we'll have to wait until morning.

Greg Ip reminds us that the decision of how to word this press release was frought with difficulty. (WSJ subscription required)

Some officials feel that inflation risks have risen, so the Fed should give itself more flexibility in how it responds to incoming economic data, with a half point move if necessary. But other officials believe communicating their limits disruptive volatility in the markets, and they should continue to say rate increases will be measured as long as Fed officials really expect that.

The last sentence looks like a typo, but I think you and I know what he's saying.

Fed chairman Alan Greenspan fueled speculation that "measured" would be dropped when he declined to use the word in his testimony in mid-February to Congress. But he did question why long-term interest rates in the bond market are so low, calling them a "conundrum."

And Mr. Ip knows who to go to for a quote. Clarida is a fine economist who seems to come closest to explaining what happened.

Richard Clarida, economic strategist at Clinton Group, a New York hedge fund, says when the Fed tightens credit conditions, it relies on the bond market to do some of its work by boosting long-term borrowing costs. The fact that, up to this point, it had not left Mr. Greenspan two options: drop "measured" and raise short-term rates faster, or use the "bully pulpit" of his congressional testimony to push long-term bond rates higher. Since bond yields rose sharply after Mr. Greenspan's testimony, Mr. Clarida says the Fed concluded it can stick with "measured" rate changes for now.

But still I'm not sure. If the CPI doesn't take too big of a jump and the bond market calms down, then maybe it's ok to leave the word "measured" in. But if the CPI is higher than expected tomorrow, then long term rates go even higher--in part because the word "measured" is still in.

Of course, if Clarida is right, then that's just what the Maestro ordered.

One last thing from Ip's article.

The Fed also raised the rate on the less important discount rate, charged on short-term Fed loans to commercial banks, to 3.75% from 3.5%. Just 10 of the Fed's 12 reserve banks requested the increase in the discount rate. It was unclear why the Kansas City and Dallas banks did not.

I'm sure that K.C. and Dallas will make their request tomorrow. That occasionally happens.

Wow. I can't wait until the minutes to this meeting are released.

Read it here. I was wrong (though I was certainly not alone) in thinking that the word "measured" would be missing.

It's still there.

Can't wait for the minutes.

Can't wait to see what this does to fed funds futures (not to mention other markets).

Will the dollar fall in late trading? I suppose so.

Right now I need to teach a class on this stuff. Back in a couple hours.

UPDATE: I didn't catch this before I had to run to class, but Kash at Angry Bear did. The wording of the press release does contain a nugget for the inflation hawks.

Output evidently continues to grow at a solid pace despite the rise in energy prices, and labor market conditions continue to improve gradually. Though longer-term inflation expectations remain well contained, pressures on inflation have picked up in recent months and pricing power is more evident. The rise in energy prices, however, has not notably fed through to core consumer prices.

They are careful to say that "longer-term inflation expectations" or "underlying inflation" are expected to be contained. They also do say that

The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal.

How will the markets take these words. Will they interpret this action favorably? Kash at Angry Bear has a chart that shows that the bond market took a dive. They apparently don't like the word measured. The whole tone of the thing seems weaker than what the market was expecting.

More to come...

At the end of tomorrow's FOMC meeting, we will receive the usual press release telling us whether the fed funds target will change and by how much. But for the last few meetings, there has also been a specific word in that press release that seems to have taken on a life of its own. That word is "measured," as in "the Committee believes that policy accommodation can be removed at a pace that is likely to be measured."

If that word is missing from tomorrow's press release, perhaps simply by omitting that key sentence, it will spur a flurry of conversation in the MSM as well as on the economically oriented blogs (like this one). Reuters has this to say going into the meeting.

NEW YORK (Reuters) - The dollar rose to two-week highs against the euro and the Swiss franc on Monday on speculation the U.S. Federal Reserve may signal a more aggressive pace of interest rate rises at its meeting Tuesday.

The Federal Open Market Committee is widely expected to raise official U.S. interest rates on Tuesday for the seventh consecutive time by a quarter-percentage point to 2.75 percent, further widening the interest rate differential over the euro zone where the ECB's minimum bid rate is 2 percent.

Some expect the Fed could signal a more aggressive stance by removing from the statement accompanying its decision on monetary policy its oft-repeated pledge to raise rates at a "measured" pace.

"The removal of the word 'measured' ... would be positive for the dollar as it suggests the Fed is giving itself room to raise rates at a faster pace later this year," Bank of New York currency strategist Michael Woolfolk told clients in a note.

Late afternoon in New York, the euro had its sharpest one-day fall since the first week of the year, down 1.1 percent from late Friday to $1.3165.

It's a situation that I would not have forseen nine months ago. I wouldn't have expected a single word to linger in the press releases for this long and have such significance attached to it. It's almost as if the removal of the word will, in the minds of some, signal that a 50 basis point increase at the next meeting is a foregone conclusion. I certainly wouldn't go that far, but you and I both know that some people will.

Is the removal of "measured" a prerequisite for more agressive moves going forward? Probably. But that's a situation that the FOMC seems to have backed into by virtue of leaving the word in there for so long. When asked about this last summer (pre-blogging days, so I don't have a link), my response was that "measured" probably meant that rates would be raised 25 b.p. at a time with an occasional break where there is no change. Ah, but that is ancient history, before the term "measured" acquired a policy definition--or so it would seem.

For review: check out these fed funds futures charts from a couple weeks ago at macroblog.

All in all, I think the FOMC is probably going to opt for the 25 b.p. increase tomorrow and remove "measured" from the press release. The wording change will be mostly to give them a degree of freedom over whether and when the policy stance can shift into a more aggressive posture. We can then take a couple weeks to contemplate it before getting the minutes to tomorrow's meeting. If the word "measured" is removed tomorrow, then the date of the release of the minutes will be eagerly anticipated by us spectators out in the markets, academia, and the blogosphere.

And what news article on the dollar would be complete without this?

Under pressure from Asian currencies too, the euro slipped to a two-week low against the yen, at 138.31 yen , because of a news report purporting China may be getting closer to increasing the flexibility of its pegged currency regime.

The yen was helped by a report in the Beijing Daily saying China may expand its yuan currency trading band.

The yuan has been pegged since the mid-1990s at a rate of about 8.28 per dollar. If it is allowed to move more freely, it is widely expected to appreciate against the dollar.

"The People's Bank of China will gradually exit from daily forex transactions. The band within which the renminbi exchange rate floats may be expanded to 0.6 percent or 1 percent from the current 0.3 percent," the newspaper said. It did not mention a timeframe for any changes to the currency regime.

"Is it jawboning on the part of Chinese officials? We're not 100 percent sure," said a trader with GAIN Capital in Warren, New Jersey. "If it is true, then that should lead to dollar weakness."

And so it goes.

I'm catching up on a stack of journals and papers during spring break. This is from the Minneapolis Fed Quarterly Review. Given this blog's occasional updates on the inflation targeting debate, I thought it was appropriate. Stern and Miller argue in favor of inflation targeting.

The last two sentences:

The important practical step in adopting an inflation targeting strategy is to find a small set of observable variables that bear a stable long-term relationship with inflation. We believe this is an important issue for research.

Money growth (assuming constant velocity) and....?

They reject constant money growth rules in the paper as giving "too little weight to output stabilization to satisfy many government officials or the public." They also make an exception to an inflation targeting rule in the case of coordination failures, which begs the question of how to recognize a coordination failure when you're in one. I don't think that's a trivial question.

But it is a thought provoking short paper.

Michael Moskow, for one, is not.

From a Reuters article:

Unlike several of his FOMC colleagues, the Chicago Fed chief said he was "cautious" about inflation targeting, terming it a concept more useful in countries that have had inflation crises.

"Inflation targeting is not something you can move into right away," he told reporters after the speech. Studies have shown "no evidence" that inflation targeting is helpful, Moskow added.

Fed Chairman Alan Greenspan does not favor inflation targeting, but some Fed officials have said that it would make the Fed's thinking more transparent and contribute to price stability.

The Fed's policy-making group discussed targeting as a special topic at its last meeting in early February.

The "no evidence" line probably refers to NBER working paper number 9577 by Ball and Sheridan (2003).

Click here for the Fed's Beige Book.

Lately, when the Beige Book comes out, I've been skipping right down to the section on prices.

Retail prices were generally flat or up modestly; however, businesses continued to face rising input costs, and a number of Districts indicated greater ease in passing along price increases. Prices for finished goods were reported to be increasing modestly in Richmond and Minneapolis, but almost all of the other Districts characterized retail prices as flat. Cleveland and Chicago reported that motor vehicle prices were being reduced by increased incentives and discounts. A number of Districts also noted ongoing declines in apparel prices.

Despite the stability in consumer goods prices, manufacturers in a number of Districts--including Boston, Cleveland, Kansas City, and Dallas--indicated that they have been finding it increasingly easy to pass along price increases; Philadelphia producers anticipated greater ability to boost prices in the near future. Also, truckers in the Cleveland and Atlanta Districts indicated that they have been offsetting rising fuel costs with surcharges.

A number of Districts reported persistent pressures on input costs, though some noted that these have eased since the last report. Firms in Boston, Richmond, Atlanta, Minneapolis, Dallas, and San Francisco reported sizable increases in prices of various raw materials. The most commonly mentioned were construction materials (especially steel) and fuel. Quite a few Districts also mentioned continued rapid escalation in health insurance costs, though San Francisco indicated that these have decelerated. More generally, New York, Cleveland and Chicago indicated that input cost pressures have abated somewhat since the last report.

I don't think this will drastically alter market expectations.

Macroblog has another update on the fed funds futures. Check it out.

FYI from Reuters:

RICHMOND, Va. (Reuters) - A long-simmering debate over whether the Federal Reserve should adopt a formal goal for U.S. inflation moved to front burner on Tuesday when two policy-makers backed the idea in separate speeches.

At the Fed's rate-setting meeting in February, the policy committee opened discussions about inflation targeting -- an idea Chairman Alan Greenspan opposes -- but further talks were put off amid divergent views.

Richmond Fed Bank President Jeffrey Lacker said in a speech at the University of Richmond an inflation target would help keep concerns about rising prices in check and boost transparency at the central bank.

"Ambiguity about the Fed's long-run inflation intentions has outlived its usefulness," he said. "I believe that the adoption and announcement of an explicit, numerical, long-run inflation target by the Fed would enhance the effectiveness of monetary policy."

and...

Philadelphia Fed Bank President Anthony Santomero also backed an inflation goal in a speech in Berlin, calling it a "reasonable next step in the evolution of U.S. monetary policy."

Read the full article here.

Refer also to one of my previous posts on the release of the minutes from the last FOMC meeting.

Greg Ip of the Wall St. Journal reports on the possibility.

Some analysts believe the Fed's openness has contributed to the low level of stock-market volatility and the narrow spread between yields on Treasurys and riskier corporate bonds. "The low price of risk is a pervasive feature of financial markets," says Tom Gallagher of ISI Group, an economic research firm. "Much of this could be due to monetary policy." He says that volatility in the stock market began to decline about the time Mr. Greenspan first used the words "considerable period" to signal a long period of low interest rates.

And later in the article,

But the Fed's willingness to forecast its interest-rate plans reflected an unusual confidence in those plans resulting from unique, and likely temporary, circumstances. Interest rates were exceptionally low, so they obviously had to rise. But the risk of inflation also was low, so the pace could be leisurely. "The crucial difference between now and in the past is an extraordinary productivity acceleration," Mr. Greenspan said last April. "That means that the price pressures are not anywhere near where they would be under normal circumstances. ... It means that you can go in a much more measured pace."

Since then, a lot has changed. The federal-funds rate, at 2.5%, is approaching a range in which Fed officials believe it will no longer be "accommodative," that is stimulating spending. Meanwhile, the economy's spare capacity has diminished, productivity growth has slowed, and the dollar has dropped, so inflation risks have risen.

See macroblog for more.

And then there's this news (Reuters) from today...

The benchmark 10-year note slid 29/32 in price, driving yields up to 4.38 percent from 4.27 percent on Friday. The break of 4.30 percent took yields to the highest level since early December and triggered a wave of technical selling.

Just another thing to keep an eye on.

The leader to The Economist's article on the Fed and inflation this week ends with the following:

During the past century, every monetary rule has eventually broken down: the gold standard, the Bretton Woods system of fixed exchange rates, and monetary targeting. Now it seems that strict inflation targeting may not be a panacea either. It would be foolish for the Fed to sign up for crude inflation targeting just as it goes out of fashion.

Fair enough. Inflation targeting has pros and cons, and I haven't been convinced yet that the pros outweigh the cons. In a perfect world, it would be easier to convince me, but... I don't have to finish that sentence, do I? That paragraph could be the end of a nice article explaining the pros and cons of rules vs. discretion and the Fed's dual (and somewhat contradictory) objectives.

But it wasn't. For instance, they say,

Some central bankers in Britain, continental Europe, Australia and New Zealand have said publicly that monetary policy needs to take more account of asset prices and that sometimes interest rates may need to rise by more than if the sole objective were to keep consumer-price inflation within target.

In a recent article, Otmar Issing, the chief economist of the European Central Bank (ECB), threw down the gauntlet to the Fed. He argued that it is hard, but not impossible, to identify when asset prices are overshooting; there are benchmarks against which valuations can be judged. If prices look frothy, central banks should signal their concern. And they should certainly avoid contributing to “unsustainable collective euphoria”. Central banks should also look out for the surge in money and credit which often accompanies a bubble.

The accompanying article says much the same thing.

Back in 2001, the president of the St. Louis Fed, William Poole, gave a talk at my campus that makes a number of important points on this issue. There's a lot of information in asset prices, but the Fed should not target them directly. One of Poole's more salient points is this,

A widely known result from control theory states that, with one instrument, the policymaker can at best achieve one policy objective. That objective, in my view, ought to be a low and stable rate of inflation. As a matter of logic, therefore, pursuing a separate stock market objective means compromises of some sort on the inflation objective. Clearly, targeting the stock market might come at a high price. Once the Federal Reserve compromises on its price stability goal, inflation and inflation expectations build up. Experience shows that inflation expectations are persistent, and inflation fighting tends to entail recessions. Because permitting the economy to run off track has negative consequences for the stock market, any effort to target the stock market is likely to be self-defeating.

Or, to extend that point to the present discussion, what do you do when asset prices and the CPI diverge, as The Economist suggests is the case, this time for housing values instead of the stock market? And that brings up an even more troubling question of what do when the stock market is flat, the CPI rising moderately, and housing going through the roof?

I don't know either. I suppose you can use the usual array of blunt policy instruments, but that means that sometimes the CPI growth could go dangerously low (or negative). Again, The Economist:

Given the elusiveness of a perfect price index, central banks should keep using conventional, narrow inflation targets, but be prepared to undershoot them temporarily if house or share prices soar.

Not a good idea. Brad DeLong agrees. Seems like they are asking the Fed to target relative prices AND nominal prices. I don't think they have enough policy instruments to do that without there being some rather serious consequences.

John M. Berry, columnist for Bloomberg weighs in.

Paul Krugman's latest NY Times piece gets it partly right. First, the not-so-good:

But privatization "as a general model," he said, "has in it the seeds of developing full funding by its very nature." Nice metaphor, but what does it mean? Clearly, he was trying to create the impression of links where none exist.

Swing and miss. Private accounts must be fully funded. (There are no credible proposals to the contrary.) Ergo, if fully funding Social Security is a goal, private accounts represent a means to achieving that goal. Granted, it's not the only way, but it is a way. Seems to me that's the link he [Greenspan] was going for, and it's correct as far as it goes, whether you agree with private accounts or not.

He does get a couple of hits though:

Privatizers claim that financial markets won't be disturbed by all that borrowing because the Bush plan prescribes offsetting cuts in guaranteed benefits for the workers who open private accounts. Mr. Greenspan, who does know a thing or two about markets, put his finger on the reason why those prospective future benefit cuts wouldn't offset current borrowing in the eyes of investors: "Well, the problem is that you cannot commit future Congresses to stay with that."

Valid point in general, so it's a hit. However, I think decision day on this is still many years in the future. The financial markets will not pull the trigger until and unless private accounts are unsuccessful to the point that Congress will be tempted to break the commitment to lower benefits. If you are confident about private accounts, you won't worry about this as much. If you don't think private accounts will deliever the goods, it's an entirely rational point to raise.

Yet the chairman managed to avoid admitting the obvious - that borrowing on the scale the Bush plan requires would substantially increase the risk of a financial crisis. And the headlines didn't emphasize his concession that crucial critiques of the Bush plan are right. As he surely intended, the headlines emphasized his support for privatization.

Two ideas in one paragraph. The first sentence belongs with the paragraph which preceeded it (above). The last part is correct. The headlines did emphasize his [Greenspan's] support for privatization. No doubt about that. Is it what he intended? Well, you could argue that he's been a central banker long enough to know what the headlines would be if he said certain things. The fact that he said them anyway is circumstantial evidence in Krugman's favor.

I can't really comment on the last part of his column directly, though I wish I could. I'll explain why and do the best I can.

One last point: a disturbing thing about Wednesday's hearing was the deference with which Democratic senators treated Mr. Greenspan. They acted as if he were still playing his proper role, acting as a nonpartisan source of economic advice. After the hearing, rather than challenging Mr. Greenspan's testimony, they tried to spin it in their favor.

But Mr. Greenspan is no longer entitled to such deference. By repeatedly shilling for whatever the Bush administration wants, he has betrayed the trust placed in Fed chairmen, and deserves to be treated as just another partisan hack.

I did not see the hearings. I was working on more pressing matters on Wednesday, and on Thursday I was teaching. C-Span sadly has not rebroadcast the hearings, at least not to my knowledge (and I have checked their website every day). Often they replay these in the evenings or later in the week, and I'm very disappointed that they haven't done so this time. I can say that from previous hearings that I have seen on C-Span, the treatment was anything but deferential (at least since the recession) from the Democrats. One of the reasons I watch them is for the entertaining way in which the Democrats verbally lash him and he responds in such a soft-spoken, even-handed way.

However, I did find this quote on Rueters:

"I do have to express skepticism that telling workers losing their jobs ... 'Do not despair. Private accounts are coming' will be less a morale booster than I think you implied," said Rep. Barney Frank, a Massachusetts Democrat.

I suppose you could deliver that line in a deferential manner. It could also be delivered with the implication that he's a partisan hack. Unfortunately, I did not see the delivery, just the words.

Alan Greenspan left out one little word in his testimony to Congress this week: "measured."

What does this mean? It's hard to say for certain right now. We aren't even totally sure what the word itself means for policy, much less what it means when the word is left out of the discussion.

Since the Fed started using the word "measured" in its press releases several months ago, I have interpreted it to mean the following. The fed funds rate will be raised 25 basis points at a time in a series of meetings over the next 18 to 24 months with occasional breaks in the increases. Since then, there has not been such a break. Every meeting since mid-summer has resulted in a 25 b.p. increase. If you would have asked me in June if we would have had a meeting between then and now that left rates unchanged, I would have said yes. I would have been wrong. And yet, in the days leading up to each meeting, I have correctly predicted that rates would go up. Clearly the preponderance of the news since June has been positive. Not enough to please everyone, but enough to render my June definition of "measured" a bit out of step with reality.

So count me as rather unsurprised that Greenspan ditched the word. Maybe it was the right word in June, but no longer. Or maybe the word doesn't mean the same thing anymore.

Today, the markets are expecting rate increases at the next three meetings. The IEM is only looking at the next two, and it agrees. Who am I to disagree? In the absence of any developments between now and then, I think the next two, and quite likely three, are almost a foregone conclusion. After that? Ask again later.

And yet, the long bonds show no fear. Yield on the 10 year is still below 4.2%. In June, I told our local media that such a result would be possible if the financial market believed the Fed was resolute in fighting inflation. After all, in June, there was some upward pressure building on yields as the markets started to turn bearish. I kept repeating that for the remainder of 2004 as I tried to explain the apparent paradox. I still think that my explanation was right for the 3rd and maybe the 4th quarter, but I told people that I would expect to see a little steam coming out of the bond market by the end of the year or early 2005. I'll give myself partial credit on this one. I wouldn't have predicted the yield to be this low in mid-Feburary.

Conventional wisdom would say that the 10 year yield has to start to move up by the time the Fed finally reaches a "neutral" policy stance, whatever that turns out to be. Is this odd situation we find ourselves in due to the fact that foreign central banks are soaking up any bonds we put out there? Brad Setser seems to think so, and it has him worried. However, I think the negative scenario he paints needs a catalyst to get it started. It's unclear precisely what that catalyst might be. (If it was clear, this post, as well as many others on my favorite econ blogs lately, would be unnecessary.) Setser has a rather general hypothesis that should provide us with a good amount of blog fodder.

The current system is delivering rapid growth in China. But that does not mean that the current system does not also impose substantial costs on China. Over the next two years, Nouriel and I suspect those costs will become increasingly apparent, and China's willingness to continue to "overfinance" the US will fall -- forcing the US to start to adjust ...

Obviously, that is a debatable proposition, but given its importance to the global economy, it also something worth debating!

Indeed.

And so, a post that began with the observation that Greenspan failed to say a certain word ends with the speculation that something very critical lies beneath the surface of that story. Interest rates may need to go higher to get foreign private investors to carry the load now being borne by foreign central banks. How high? What is "neutral"? Is neutral enough? These are questions that no one can answer right now, but as Setser indicates, this is an important debate.

For more, see Reuters and the Washington Post, just to name a couple of today's stories. This isn't going away.

I like what they've done with it. Well organized. Everything at your fingertips.

"If you're going to move to private accounts, which I approve of, I think you have to do it in a cautious, gradual way."

--Alan Greenspan, Feb. 16, 2005

That is what I've been saying for weeks.

There's more from this NY Times article.

"Could we create the personal accounts without any substantial borrowing for the transition?" [Senator Shelby] asked. "And if so, how?"

"Well," Mr. Greenspan replied, "obviously if you raise taxes, you could."

"What about cutting benefits?" Mr. Shelby asked.

"You could certainly do it that way, too," the chairman said.

Now that's the Alan Greenspan we all know.

Anyway, more on this later. I'm still hoping that C-Span will run it tonight and post a link.

UPDATE: Nothing on C-Span. I am very, very disappointed. But take heart, macroblog has much more.

In the last day or so, speculation has increased that Greenspan may address Social Security privatization when he ascends the Hill today to meet with the Senate Banking Committee.

Will he give his opinion?

The latest Reuters story as of this post is here.

MSNBC story here.

Bloomberg lays it all out here. I especially like the ending:

"John and Jane out in Peoria aren't going to change their opinion on Social Security because of what Alan Greenspan says," he said.

Probably not. If I bump into John and Jane on the street, I will ask them. (I do know a few folks named John in Peoria, none named Jane.)Gotta love the gratuitous Peoria references.

Last week's lackluster GDP notwithstanding, I think it is a safe bet that the Fed will raise rates by 25 basis points.

Macroblog came across something rather amusing related to the GDP numbers. Read it.

The ExecMBA student who sent him the link had the best line:

Those crazy Canadians are stealing our growth!

Now, if this sort of thing can happen now, just think what complexities will be introduced when Molson merges with Coors.

It boggles the mind.

Paul Krugman says what many of us are thinking.

The last name one often hears is Ben Bernanke, currently a member of the Fed's Board of Governors. (Before going to the Fed, Mr. Bernanke was chairman of the Princeton economics department, where I'm on the faculty.) If Mr. Bernanke were appointed directly from his current Fed position to the chairmanship, there would be general acclaim. But he may soon move to the Council of Economic Advisers. Why?

Surely it's not because this administration, with its disdain for technical expertise in all fields, wants his advice. I hope I'm wrong, but my guess is that what's intended for Mr. Bernanke is a form of hazing: he will be expected to prove his loyalty by defending the indefensible and saying things he knows aren't true.

That might seem a tolerable price to pay for the Fed chairmanship - but a year of it might well make Mr. Bernanke damaged goods from the point of view of the markets.

It's a dilemma. I don't have any sympathy for the administration's perplexity. But I do wish Mr. Bernanke the best of luck, and hope he knows what he's doing.

I wish him the best of luck too. It is a dilemma. "Defending the indefensible" is a little strong for me, but like I said recently, jumping directly from the CEA to the Fed would make me nervous.

Brad Setser has some insights.

Personally, I began thinking Bernanke had an inside track shortly after he was appointed to the Board. Lately, however, this has been a much harder race to handicap.

R. Glenn Hubbard has been the latest name thought by some to be a frontrunner. Martin Feldstein could face a tough fight. John Taylor appear to be out of the running according to the New York Times. (Pity.)

Setser is decidedly cool on Hubbard. I understand. I would be concerned about the appearance of this being a political appointment. (I'm a realist, I know that there's a political element, but I'd like a little effort to put some distance between the White House and the Eccles Building.) If any president appointed such a recent CEA chair, it would raise questions.

In the end, I think Hubbard would be confirmed if he were to be appointed. (Though I think the hearings would be exciting... scratch that, the hearings will be exciting no matter who gets appointed. They should sell tickets for this one.) Actually, I think any of the frontrunners would be confirmed, but Bush needs to think this one through very carefully. Like it or not, Bush's fiscal policy will be on trial at those hearings. The appointee must be able to (1) articulate that he (or she) would maintain the current level of independence at the Fed and be (2) credible when saying it.

Anyone can do the first part. It's the second part that will make all the difference.

We haven't heard the last about this.

Governor Kohn elaborates on the costs and benefits of greater communication from the Fed.

The minutes are not an attempt to articulate a single consensus explanation of our actions or outlook, but rather, reflecting a strength of the FOMC, they summarize the give and take in Committee discussion arising from differing perspectives on difficult issues.

Early release of the minutes could have costs if Committee members became more guarded in their discussion out of concern about the effects of their remarks when reported or if, over time, the minutes themselves became less comprehensive. In my view, neither of these developments is an inevitable consequence of the new schedule, and I am sure the Committee will resist any temptation to allow them to occur.

I love the last sentence.

Over time, I anticipate further steps toward explaining our views, but at a pace that is likely to be measured.

Read the whole thing.

From those FOMC minutes released earlier this week:

Meeting participants supported the principle of openness and transparency, but debated the possibility that the markets would misinterpret the minutes and that the prospect of early release would lead to either less productive discussions at the meetings or to less comprehensive, and therefore less useful, minutes. [emphasis added]

No additional comment needed.

I was thinking about a post on this today, but Macroblog beat me to it.

Quoting Rebecca Byrne at TheStreet.com,

While most investors had expected several more interest rate hikes this year, confirmation from the Federal Reserve came as an unwelcome surprise Tuesday...

"The FOMC minutes for the December meeting were considerably more hawkish than generally expected," said Stephen Stanley, an economist at RBS Greenwich Capital. "The committee has clearly become much more confident in the sustainability of the expansion."

The stock market slipped deeper into negative territory in the wake of the news and bonds sold off. The Dow Jones Industrial Average lost 96 points to 10,631 on the session, while the Nasdaq Composite slide 44 points to 2108. Treasury bond yields rose to 4.28%.

Oh, and this is what Macroblog had to say about the decision to release the minutes early.

Before now, the minutes of a particular meeting were not released until after the subsequent meeting, so the information contained therein was somewhat moot. The change in communication policy received scant attention in the press, but in the long run it may very well be more important news than that 25 basis points.

You bet'cha. When I heard the news last month, I filed it away thinking that it would probably turn out to be a very good thing in the long run, but it might cause some strange things to happen in the short run.

I wish I would have blogged it so I could really say, "I told you so." But I think a lot of economists would probably say (and would have said, and some probably did say) the same thing.

Ok, so tell me... was this revelation from the Fed something that should have really taken the market by storm? Were there traders out there who were thinking that the Fed was done raising rates and who suddenly saw the light?

Did we receive any new information? Possibly. Some people are thinking that this might signal that the Fed is thinking about moving more than 25 basis points. Unlikely, but I can see where they are coming from.

As I write this, I'm listening to CNBC, where they are having a debate on whether this early release of the minutes is a good thing. The comments are pretty predictable and mirror what I've been thinking. One comment was that there were some who thought that the Fed would pause at the next meeting who now realize that they will not. Perhaps.

Right now I would regard the first meeting of the year as a virtual certainty of a 25 b.p. hike and the second meeting as having a 75-85% probability of a 25 b.p. hike.

But I will say that the intermeeting release of the minutes is almost sure to cause some excess volatility until we figure it out. In the end, I think it will turn out to be a good thing. Could be interesting. I'll be reporting it here.

Anyone want to disagree with the conventional wisdom that the Fed will raise interest rates again tomorrow?

Anyone?

(*insert sound of crickets chirping*)

I thought not.

The question is whether the word "measured" will be in the press release. I say it will.

Update: They did, and it was.

A Term at the Fed by Laurence Meyer

This book was fantastic for a Fed enthusiast. Meyer was a Governor at the Fed from 1996 until 2002. He tells some entertaining tales of discussions at FOMC meetings during those years. The accounts of his dealings with the media are particularly interesting. I remember when he first came onto the Fed and made some rather provocative statements that were reported in the Wall St. Journal. He wasn't your ordinary Governor, and that's gives the book some character. Meyer has a way of humanizing Alan Greenspan that is critical yet respectful. His upfront approach comes through in the book. Economists are by their nature storytellers, and Meyer can spin a yarn.

Be aware that it's not a long book. If you're looking for deep theoretical analysis, don't bother. If you're looking for a quick, pleasant read about a time when policy was made by the seat of your pants when the old rules stopped working and no one knew why, then this is the book for you. He tries to recount these policy discussions in a way that reflects what was known at the time rather than using too much hindsight. If you studied the economy in the 1990s, it will be a walk down memory lane.

It's about as close to a "page-turner" as an economics book can get. It passed the "student test" here as well. Our econ majors loved it.

When Alan Greenspan spoke last week, the media heard only one thing: a warning about the trade deficit.

Case in point: (entire article from Forbes.com here)

Stocks fell substantially Friday as Federal Reserve Chairman Alan Greenspan sounded a warning over the nation's spiraling trade deficit, while rising oil prices raised fresh worries about energy costs heading into winter. The Dow lost more than 104 points in afternoon trading.

Wall Street paid close attention to Greenspan's unusually frank assessment of the trade imbalance and its effect on the U.S. economy. The Fed chairman said the economy was resilient thus far, but would be vulnerable to foreign influence should the deficits continue to build.

"Certainly that has investors worried, though I'm not entirely sure why Greenspan chose to make a case out of this," said Lincoln Anderson, chief investment officer at LPL Financial Services in Boston. "The lower dollar will eventually force importers to raise prices, and that'll help cut the trade deficit. But nonetheless, it was unusual for him to speak out on it like that, and it's having an effect."

"Unusually frank?" "Make a case out of this?"

Read the whole speech.

A little out of the usual territory for a Greenspan speech? Maybe. But I think the media overreacted. The stock market definitely overreacted. Nonetheless, there's really nothing in Greenspan's speech with which I would take issue. I say pretty much the same thing in my open economy macro course, and have for some time. I wouldn't call his comments "unusually frank." I've seen central bank speeches that were unusally frank, and in my opinion, this wasn't.

At best it was a little curious that he chose to talk about the US trade deficit at a panel discussion on the euro. However, I think most economists can make the connection here. I've lectured to my students until I am blue in the face that the US trade deficit could lead to a weaker dollar, that is, a stronger euro (which is exactly what is happening). And an abnormally strong euro is a bit uncomfortable for Europe... ok, "brutal" is one word that has been used. Sometimes I wonder whether the Europeans are more upset with our appetite for cheap Chinese goods or with our foreign policy. Some days it's a tossup.

This is a no brainer. Purely as a matter of getting it on the record ahead of time, I'm predicting a 1/4 point increase tomorrow.

At this point in time, another 1/4 point in December is almost a sure thing. I wouldn't have said that last Thursday, but things are really moving in that direction.

I promise a longer post on this later.

Taggert Brooks quotes Fed governor Ferguson's excellent speech from last week. The topic of the speech is the equilibrium real interest rate--at least that's the title. But the real message of the speech is about the speed of adjustment back to equilibrium. Very relevant stuff.

It's not every day that your hometown is featured in a Federal Reserve publication. Read about the influx of new immigrants into Pelican Rapids, MN and a number of other 9th district towns and cities.

The FOMC voted to raise the fed funds target by 25 basis points. No surprise, of course, but the real news might be in the statement accompanying the decision.

They write: "Despite the rise in energy prices, inflation and inflation expectations have eased in recent months."

Translation: If there are no further signs of inflation picking up, this trend of a rate increase at every meeting need not continue. Maybe we'll hold steady on November 10.

They continue: "With underlying inflation expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability."

Translation: Don't count on us holding steady on November 10.

Let's be clear. They still want to keep rates moving up, probably to between 3 and 4% in the next year or so, but they don't have any strict timetable for it. They will pause once or twice when it seems like the right thing to do. Whether November 10 is that time or not depends on employment reports, GDP reports, and other economic news between now and then. Right now, I'd put about 50 to 60% certainty on another increase at that time. That's enough uncertainty to make me want to watch the numbers very closely.

People often ask what this will do to mortgage rates. This time, probably not much. If this move is seen as holding the line on inflation, I wouldn't expect a sudden jump in mortgage rates. They might even temporarily fall as they did over the latter half of the summer. (I correctly called this one back in June for a local TV newscast. Unfortunately the entire story script is not on-line.) I do think, however, that a steady upward drift in mortgage rates is in the cards for 2005, maybe to around 7% by next year's end.

But that's if nothing else changes between now and then.

The Federal Open Market Committee meets Tuesday on whether or not to raise (lowering is pretty much out of the question) the fed funds target. Smart money is on a 25 basis point increase. Holding steady at this point might be taken by the market as a negative signal. The Fed is often accused of juicing the economy before an election, but ironically, this time a more accommodative policy probably wouldn't have the desired effect. Expectations matter a lot these days. Alan Greenspan has been instrumental in making the Fed more transparent, and it has made the market a lot better at predicting the Fed's actions. On balance, that's a good thing, but it does add a constraint to their decision making process. Leaving rates alone would raise a lot of questions in the market.

The question is, where do rates go after Tuesday? Consumer confidence is slipping. Clearly the Fed would like to get rates up to a more appropriate level over the next year, but they won't want to risk slowing things down too much too fast. Right now, I would expect that the meeting after next might give us pause in the action. But even so, I don't see any reason why they won't stay the course towards a fed funds rate of 3 to 4% in the next 12 to 18 months. Look in the press release for indications of where they might be going on November 10.

And by that next meeting we'll know who the next president will be.

We hope.