William J. Polley

February 11, 2008

Poole: Best bet is that we will not have a recession

Via Reuters:

ST. LOUIS (Reuters) - The U.S. appears likely to avoid an economic slowdown but the chances of a recession have risen, St. Louis Federal Reserve Bank President William Poole said on Monday.

"I think the best bet is that we will not have a recession," he said in response to questions after a speech to the St. Louis chapter of the National Association for Business Economics.

However, Poole later told reporters, "There is no question that the odds (of recession) are higher than they used to be."

...

"So far we're standing with very sticky shoes on that slippery slope," he said. "We do watch it very closely; there's no question that there's a risk."

Poole said the housing market continues to be a problem, but based on his readings of retail and auto sales data, consumer spending is flat but is not crashing.

One glimmer of hope is that while recessions are typically characterized by large business inventory overhangs, stocks are currently lean.

But Reuters may have buried the lede.

In his prepared speech, Poole said efforts to provide guidance on the likely direction of interest-rate policy often can sow more confusion than clarity.

"I have concluded that an ... attempt to provide forward guidance in the policy statement causes more communications difficulties than it solves," Poole said. "A key reason is that the economy is subject to more shocks and reversals than one might think."

Those shocks require the central bank to change interest rates more frequently that he would have thought likely before he arrived at the regional Fed bank 10 years ago, he said.

Here's a link to the speech.

Posted by William Polley at 11:45 PM | Comments (0) | TrackBack

December 22, 2007

Mankiw: Let the Fed do its job

Greg Mankiw writes in the New York Times today:

The question on the minds of many in Congress and in the White House is this: What they should be doing now to keep the economy on track? The right answer: absolutely nothing.

This advice isn’t easy for politicians to follow. Because economic downturns mean fewer jobs and falling incomes, they are painful for many families. Voters can confuse inaction with nonchalance and send incumbents packing. But just as patients should avoid doctors who recommend radical surgery for every ailment, voters should be wary of politicians eager to treat every economic ill. Sometimes, bed rest and wait-and-see are the best we can do.

Indeed it is true that the incumbent party does poorly, as Mankiw shows on his blog today (via Statistical Modeling).

Thus, Mankiw has a point, and later on in the article when he puts more faith in the Fed's ability to cope with the business cycle than Congress and the White House, I would also agree to a great extent. Whether the Fed is able to stave off a recession remains to be seen. If indeed a recession is to begin this quarter or the next (I wouldn't bet an awful lot of money on it, but it is a non-trivial probability), then what the Fed did in December or what they do in January will matter little. Likewise, if the economy rebounds in 2008 it probably wasn't the extra quarter point this month that saved us. Iacta alea est.

Posted by William Polley at 4:35 PM | Comments (3) | TrackBack

December 17, 2007

Wall St. Journal interviews Charles Plosser

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

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

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

Posted by William Polley at 10:21 PM | Comments (0) | TrackBack

December 11, 2007

Some wanted more

And so it is 25 basis points and not 50. Link to statement

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

Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks. Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time.

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

Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; and Kevin M. Warsh. Voting against was Eric S. Rosengren, who preferred to lower the target for the federal funds rate by 50 basis points at this meeting.

I am giving three final exams today (and am finishing up one of them now), so this has to be brief. Wall Street was clearly not impressed by this statement. The reasons are pretty straightforward. They were hoping for 50 basis points. (In your dreams, Wall Street.) So there was some obligatory pouting about that. But also the statement acknowledges the weakness but promises nothing more. The last paragraph (before the vote) is telling. The Fed is pointing to increased uncertainty. This is a classic instance of the committee wanting to buy a little flexibility. (We have discussed this before though I don't have time right now to find a link to the discussion.) In other words, they do not want this series of cuts to turn into anything resembling a "measured pace." They want to be able to say, "We just don't know right now."

I have to go start exam number three, so I will leave you with the best quote I have seen about the action so far. From CNN/Money.

"The Fed is not going to bail out the market. Time will heal these wounds. People don't want to hear that but it's the real world," said Rich Berg, chief executive officer of Performance Trust Capital Partners, a Chicago-based bond trading firm.

Indeed.

Posted by William Polley at 2:37 PM | Comments (0) | TrackBack

December 6, 2007

Bank of England cuts; ECB holds steady

From the NY Times:

FRANKFURT, Dec. 6 — The European Central Bank, caught between fears of rising inflation and subsiding economic growth, walked a middle ground today, leaving interest rates unchanged.

But across the channel, the Bank of England opted to take action, cutting its key rate for the first time in two years, by a quarter-point, to 5.5 percent. The bank said the credit squeeze in the United States had curtailed loans for households and businesses, denting Britain’s growth prospects.

Apparently the ECB was not of one mind on their decision....

In a rare departure from his usual discretion about the bank’s deliberations, Mr. Trichet disclosed that some bankers on the 19-member governing council had argued for raising rates.

Meanwhile, the probability of a 50 basis point ease increased from 31% to 35% (reaching a high of 37%) as measured by the binary options contracts on the Chicago Board of Trade.

Posted by William Polley at 3:29 PM | Comments (0) | TrackBack

December 5, 2007

A little good news

Productivity is up. (BLS press release)

The Bureau of Labor Statistics of the U.S. Department of Labor today reported revised productivity data—as measured by output per hour of all persons—for the third quarter of 2007. The seasonally adjusted annual rates of productivity growth in the third quarter were:

6.7 percent in the business sector and

6.3 percent in the nonfarm business sector.

In both sectors, changes in productivity are higher than the preliminary estimates published November 7, and represent the largest productivity gains since the third quarter of 2003. The upward revisions to productivity resulted from upward revisions to output—which grew 5.7 percent in both sectors—and small downward revisions to hours, which fell 1.0 percent in the business sector and 0.6 percent in the nonfarm business sector in the third quarter.

Also see the Wall St. Journal.

Does this change anything going into the FOMC meeting? In my estimation, no.

Posted by William Polley at 12:16 PM | Comments (1) | TrackBack

Martin Feldstein's two pronged approach

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

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

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

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

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

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

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

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

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

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

Add a dash of Mundell-Fleming.

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

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

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

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

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

Posted by William Polley at 12:04 AM | Comments (1) | TrackBack

December 4, 2007

Greg Ip on the upcoming Fed meeting

Greg Ip has a knack for giving you tomorrow's news today when it comes to the Fed. Here's what he's got for us today. (Wall St. Journal)

Futures markets expect at least a quarter-percentage-point rate cut and see a two-thirds probability of a half-point cut. Fed officials will likely consider the larger cut, but some might find it hard to justify when just a few weeks ago they thought they were finished cutting rates.

Some analysts say the Fed is more likely to deliver a quarter-point rate cut and drop from its statement last month's characterization of risks of weaker growth and higher inflation as equally balanced. That would implicitly leave the door open to additional easing, without leading investors to presume further cuts were coming.

Analysts also believe the Fed could improve the functioning of financial markets with either an additional cut in the discount rate -- at which the Fed lends directly to banks -- or by lengthening the terms of such loans.

And later in the article, this key insight which, although it has been expressed, probably hasn't been talked about as much as it should yet:

Fed officials' main concern isn't the current economy, though recent data have been on "the soft side," as Chairman Ben Bernanke said last week. Rather, it's that banks and other lenders, having already tightened mortgage-lending terms, will do the same with loans to small and medium-size businesses as well as credit cards and other consumer credit. Fed officials don't believe banks' reluctance to lend will go away after Dec. 31. And Mr. Bernanke warned that could "impose additional restraint on activity in housing markets and in other credit-sensitive sectors."

Subprime gets all the attention. Mortgage lending is the big story. A general recession is a real concern. But the economy can certainly ride out the subprime mess. The housing market will recover even if it takes many months. The real threat that could potentially cause a serious recession is if other credit markets besides the mortgage market start to seize up because of a generalized lack of liquidity. The Fed is simply taking out some insurance that this won't happen. But there's even so, there are no guarantees... which brings us to our next installment (see next post).

Posted by William Polley at 11:38 PM | Comments (0) | TrackBack

December 3, 2007

San Francisco Fed's Yellen still sees downside risk

Here's the speech.

Here are some excerpts:

To sum up the story on the outlook for real GDP growth, my own view is that, under appropriate monetary policy, the economy is still likely to achieve a relatively smooth adjustment path, with real GDP growth gradually returning to its roughly 2½ percent trend over the next year or so, and the unemployment rate rising only very gradually to just above its 4¾ percent sustainable level. However, for the next few quarters, there are signs that growth may come in somewhat lower than I had previously thought likely. For example, some of the risks that I worried about in my earlier forecast have materialized—the turmoil in financial markets has not subsided as much as I had hoped, and some data on personal consumption have come in weaker than expected. I continue to see the growth risks as skewed to the downside in part because increased perceptions of downside economic risk may induce greater caution by lenders, households, and firms.

...

It seems most likely that core PCE price inflation will edge down to around 1¾ percent over the next few years under appropriate policy and the gap between total and core PCE inflation will diminish substantially. Such an outcome is broadly consistent with my interpretation of the Fed’s price stability mandate. This view is predicated on continued well-anchored inflation expectations. It also assumes the emergence of a slight amount of slack in the labor market, as well as the ebbing of the upward effects of movements in energy and commodity prices. However, we do still face some inflation risks, mainly due to faster increases in unit labor costs, the depreciation of the dollar, and the continuing upside surprises in energy prices. Moreover, labor markets have continued to surprise on the strong side. All of these factors will need to be watched carefully going forward.

...

In line with the forecast-based policy I’ve described, the Committee’s decisions reflected a forward-looking and preemptive approach. In particular, I supported putting a substantial easing in place so as not to fall “behind the curve.” Given the long lags between policy actions and their impact on the economy, and the possibility that economic downturns can be difficult to reverse once they take hold, an approach that was more gradual and reactive than this would have created unnecessary economic risks.

Since the October FOMC meeting, financial conditions have deteriorated, and we have seen some unexpected softening in the economic data. These developments necessitate some rethinking of my growth forecast, and have highlighted the downside skew in the risks to that forecast. On the inflation front, I continue to expect core consumer prices to rise at a pace that is broadly consistent with price stability, although there are some notable upside risks that bear careful watching and consideration. Additional data bearing on the outlook will become available before the FOMC’s meeting next week, and this information must also be factored into an assessment of the economy’s prospects.

I'm with Tim Duy. Ignore the hawks. FYI, the Chicago Board of Trade binary options shows the probability of a cut at 93%.

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November 30, 2007

Bernanke: "Headwinds" for the consumer likely in months ahead

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

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

Posted by William Polley at 8:38 AM | Comments (0) | TrackBack

November 29, 2007

Market expectations for a rate cut become solidified

It's been a while since we have looked at the fed binary options from the Chicago Board of Trade. And there was some significant movement today too.

Implied probability of at least a 25 bp cut is now at around 87% (call option with 95500 strike price closed at 87, up 9 from yesterday's close).

Implied probability of at least a 50 bp cut is now at around 30% (call option with 95750 strike price closed at 30, up 10 from yesterday's close).

Payoffs are based on the target fed funds rate at the end of December. Hence these take into account the possibility of an intermeeting cut.

It's impossible to point to one factor as being the prime mover here. There's Donald Kohn's speech where he says,

Another consequence of operating under a high degree of uncertainty is that, more than usually, the potential actions the Federal Reserve discusses have the character of "buying insurance" or managing risk--that is, weighing the possibility of especially adverse outcomes. The nature of financial market upsets is that they substantially increase the risk of such especially adverse outcomes while possibly having limited effects on the most likely path for the economy.

See also, Frederic Mishkin from earlier this month.

We also have the steady drum beat of negative housing news along with a jump in jobless claims. Not even a GDP revision can overcome that. (Of course, the GDP revision is not fooling anyone into revising their forward looking forecast. Barry Ritholtz calls the revision "fanciful".)

But two Fed officials have expressed a clear preference to hold rates where they are. One votes at the next meeting. The other will be a voting member next year. (Reuters)

CHICAGO (Reuters) - Two Federal Reserve Bank officials hinted strongly on Tuesday that they would not support an interest rate cut in December, contending that the Fed has provided enough insurance against financial turmoil and would risk opening the door to higher inflation.

The comments from Chicago Fed President Charles Evans and Philadelphia Fed President Charles Plosser put the central bank at odds with financial markets that are anticipating a series of rate cuts over the next few months.

...

But Evans and Plosser, while acknowledging risks to the economy, suggested that further cuts to the federal funds rate, the bank's most powerful policy tool, might not be the right solution to the credit market's problems.

...

"In some circumstances, lowering interest rates may prolong the painful process of price discovery," he said in a speech to the Rochester University Simon Graduate School of Business.

I think I may use that quote in my classes next week.

The beat goes on.

Posted by William Polley at 12:06 PM | Comments (0) | TrackBack

November 8, 2007

Bernanke speaks on the economic outlook

Today is a teaching day for me, so I don't have much time. But I am currently listening to Bernanke answering questions from the Joint Economic Committee. Here is a link to his testimony. Not much about inflation in there.

As I write this and listen to the Q and A, Ron Paul is apoplectic, as you might imagine.

In other news, the ECB and the Bank of England leave interest rates where they are.

I'm giving a test in a couple hours. One of the concepts we have been discussing is the relationship of the value of the dollar to the interest rates at home and abroad. Nothing like being able to pull a question right out of the headlines.

Posted by William Polley at 10:19 AM | Comments (0) | TrackBack

November 6, 2007

Plosser tells it like it is

From the NY Times

In an unusually blunt interview, the president of the Federal Reserve Bank of Philadelphia said he already expected growth to slow to an annual pace of 1.5 percent or less. But he said he would not support another rate cut unless the slowdown appeared to be even sharper than that.

Read the whole thing.

Posted by William Polley at 5:10 PM | Comments (2) | TrackBack

Catching up... and my trip to the Fed yesterday

I figure I've logged about 1600 miles of driving in the last 11 days. That cuts into the time available for blogging. Things should improve now for a while at least.

Yesterday, I was in Chicago with my students competing in the 7th District College Fed Challenge. Three time defending national champion Northwestern University won again. Although the University of Chicago certainly gave them a run for their money. We faced U of C in the first round and thus didn't advance. Even so, the value of the program as a learning experience for our students is tremendous.

Fredric Mishkin spoke yesterday about the risk management approach to monetary policy decisions. This was the basis for the lead off question in the final round Q and A session at the Fed Challenge. By the way, all of the final round teams (in addition to our team), were unanimously in favor of holding rates constant at this point in time. The competition is real-time. Therefore having it so soon after the last meeting does sort of predispose one to holding steady. However, there was a lot of discussion and debate by all the teams about what the outlook is going forward.

As for that outlook, Tim Duy is concerned.

...One has to imagine that the Fed must be feeling a little uneasy about pulling the trigger on another 25bp last Wednesday given Friday’s employment report. Still, they likely take comfort in the belief that they drew a line in the sand with the statement, declaring a balanced risk outlook.

But can they stick to that line during a scary four months? Can they look through to that period of “moderate growth” that they keep predicting? I would like to believe they are ready to stick to their guns, but recent history is not on my side.

...

Can the Fed resist that pressure to keep cutting even if they are confident that the medium term risks are really balanced? If the “risk management” faction at the Fed continues to hold power, it seems like more rates cuts are likely, especially if there is any hint of further softening in employment or investment. That is what recent history tells us.

Standing in the way of additional cuts, however, is these new-found inflation concerns that appeared in the last statement. Declining core-inflation has been cited as a justification for Fed easing based upon decreasing estimates of the neutral Fed funds rate. I would only like to suggest that the recent history of core-PCE is not all that comforting. Looking a three-month inflation trends on an annualized basis:

I detect something of an upward trend in the past four months, on the order of 50bp – perhaps it is too early to be lowering estimates of the neutral rate? Personally, I wouldn’t break out the champagne on the inflation story just yet. It appears, however, that Fed Chairman Ben Bernanke and Governor Frederick Mishkin – the power couple in the “risk management” regime – already popped the cork.

The chart is from Duy's post at Economist's View.

This is precisely a point that was made by my students as well as most of the other teams at the Fed Challenge yesterday. This is a concern going forward. There is a very real risk that any further easing could have nasty repercussions for intermediate to long term inflation expectations. And if the Fed is going to be facing a real inflation problem in a year or two, when the economy is still trying to right itself from the subprime debacle, that's not going to be good for growth either.

See also this article by Bloomberg's John Berry.

Posted by William Polley at 11:01 AM | Comments (1) | TrackBack

October 31, 2007

A final thought on today's Fed move

Here's one paragraph from the Wall Street Journal article on the move.

Stocks and bonds sold off on the news. The Dow Jones Industrial Average ,up over 80 points before the Fed's afternoon announcement, initially fell into negative territory. Long-term bond prices, which move in the opposite direction of yields, fell. The statement appears to sharply reduce the odds the Fed will cut rates again at its December meeting, as markets had expected.

Please excuse my shouting for just a moment.... GOOD! Maybe they'll take it to heart this time.

There, now I feel better.

Comments are coming in fast and furious to the Journal's Real Time Economics blog. They are overwhelmingly harsh. Personally, I don't share that harsh assessment that this was the wrong thing to do. I don't think this was a decision that they wanted to make. Certainly it is not a decision that they thought they would have to make a few weeks ago. If they could go back and do a couple things differently, they might be tempted. Given the way things evolved, they did the best they could, came up with a better statement, and maybe learned a thing or two. Could be worse.

Posted by William Polley at 1:58 PM | Comments (2) | TrackBack

CNBC: Fed cuts target fed funds rate and discount rate by 25 basis points

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

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

UPDATE: And here it is... FOMC Statement

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

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

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

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

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

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

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

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

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

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

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

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

Posted by William Polley at 1:16 PM | Comments (0) | TrackBack

Does 3.9% GDP growth change anything?

In the very short run (like, say, the next couple hours), no. Wall St. Journal story on GDP here. The stock market, quite predictably, rallied a bit. However, it has not moved anyone seriously off of their expectations of a 25 b.p. rate cut. So, if your immediate thought was that this might buy the Fed a way out, I have to say that I don't think it's any easier. In a perfect world, expectations might have been more balanced coming into today and then this data could have tipped the balance towards doing nothing. I might wish that was the world we live in, but it's not. Felix Salmon has more.

On the fundamental question of what the Fed should do--taking everything, including expectations, into account--I'm left with the opinion that while it would be a courageous statement of principle to do nothing (and part of me really wishes they could), I think it might be too risky given the somewhat fragile state of the market. I'm really holding my nose as I say that because I don't like the idea of the Fed being pushed into doing something. But in some sense you also have to play the hand you are dealt...or the hand you dealt yourself... or something.

Commenter Kevin writes:

I think Ben's Fed has really tried to stay away from any commitments about the path of future policy moves. So I think your suggestion that they say that this will be the last cut is a nonstarter. However, what I do expect would be more guidance about the conditions for any changes - which may include taking back the rate cuts (imagine that!).

First, a clarification. When I made reference to them saying that this would be the last cut, I was using some verbal shorthand at the end of a long post (in a three part series!) Of course they will not say it in so many words. They can "say" it in their assessment of the risks to growth and inflation. It's easy to come up with some wording that would say that they are going to have a "neutral bias" (though that language is itself somewhat passé). Whether one could make that language credible is another matter.

So then what about some guidance about the conditions for any changes? Not yet, not in any formal way. That could potentially end up being part of the new communication strategy that the Fed is discussing. But not yet. And they are certainly not going to say anything today about when these cuts are going to be taken back. Not a chance. Personally, I'd like to see that guidance too. I think one could make a credible case that if 4th quarter GDP growth is above X and if average monthly job growth stays above Y and if core PCE stays below Z, then they could raise the funds rate in January or March. But they certainly aren't going to tell us X, Y, and Z (or whatever other indicators would come into play). And I really don't think you're even going to get much of a hint yet. I think the best we can hope for is a strongly worded statement that growth is stronger than anticipated, that the housing problems have not yet spilled over into the broader economy, and that the magnitude of that spillover may be less than anticipated. Furthermore, firms are getting squeezed by higher input prices. While that has not yet passed through to final goods prices, the weaker dollar is going to put more pressure on firms to raise prices. (Except that the Fed will not talk about the weaker dollar, but you get the idea.) Make it so we expect that at least 25 basis points will be taken back if this strength continues. That way, if the 4th quarter ends up being only slightly weaker, they could still get by with holding steady in December and January.

It's almost time.

Posted by William Polley at 12:45 PM | Comments (1) | TrackBack

October 30, 2007

Countdown to FOMC

I've got a full plate tomorrow, so I may not be able to post in the morning. I am going to try to arrange it to be around the computer at 1:15 (Central), though I may step out to watch CNBC for the actual announcement. So here are my thoughts after a long day of kicking this around, watching the markets, and reading the commentary.

25 b.p. still seems like what we will see. Greg Ip's column didn't push the market very much toward any real expectation that they will do nothing. But it did wring out any hope of getting 50 b.p. If that was the intent, it worked. If it helps the market get a little better perspective going forward (looking ahead to December), then it's a good thing.

Tonight I find myself thinking about tomorrow's GDP numbers and wondering about inflation. I find myself compelled to say that I really hope that the Fed can create an expectation that there will be no cut in December and stick to it. 4.5% may not be exactly neutral, but it's close. Close enough to be a good vantage point to see where we go from here.

I'm sure it is frustrating for Fed officials to have a market that responds to every bit of news as a potential tipping point, but that's the environment we live in right now. They can manage it once they recognize how sensitive everyone is to a hint of economic weakness and how entrenched the sentiment is that the Fed will rescue them. This is Mr. Bernanke's chance to establish his approach to managing market expectations. The statement tomorrow will tell all.

Enough kibitzing. It's their move.

Posted by William Polley at 9:53 PM | Comments (0) | TrackBack

November fed funds still looking for a cut

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

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

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

It should be an interesting 27 hours or so.

Posted by William Polley at 9:41 AM | Comments (3) | TrackBack

October 29, 2007

Could the Fed hold rates constant? (Part III)

One more thing, that deserves mention. Don't think that it hasn't crossed my mind that this piece by Greg Ip may (probably?) reflect some internal Fed talk that they want to get out to the public. Reuters even picked up the story in one of those rare journalism twists where the story itself is the story.

The article by Greg Ip, the Journal's Fed watcher who is known for sometimes reflecting the views of senior central bankers, said policymakers view this week's decision as a choice between a quarter-point cut to 4.5 percent and not moving at all.

Seems like there are (at least) two possibilities. Either this is supposed to prepare the market for no cut at all, or it is meant to totally disabuse the market of any thought of a 50 b.p. cut before such speculation gets out of control.

It could be a little of both. A cut is not a sure thing. It's probably still the most likely and least risky option. But I'm prepared to be wrong. I just can't imagine a unanimous vote to hold steady, whereas I can imagine a unanimous (perhaps one dissenting) vote for 25 b.p. And I wonder about the signal that would be sent if a vote to hold steady was not unanimous. Whereas if a hawkish member dissents from the consensus to cut, I think that's easier for the market to swallow (a better indicator that they figure that they are slightly below a neutral funds rate), and it would still be consistent with the tone of Ip's article. Comments?

Posted by William Polley at 11:32 PM | Comments (2) | TrackBack

Could the Fed hold rates constant? (Part II)

Tim Duy makes his stand.

And So It Begins, by Tim Duy: The Fed begins a two-day meeting today, with market participants widely expecting a rate cut. I am mentally prepared to be on the wrong side of this call, joining the lonely few, but I just can’t tease another rate cut out of the incoming data.

In my mind, the argument for a rate cut hinges on one crucial assumption – that the market is expecting a rate cut, and the Fed will not want to disappoint....

Agreed. He also says...

If the Fed fails to ease, so the story goes, they will be blamed for failure to communicate effectively. After all, given their push for transparency, shouldn’t they make an effort to send a signal when the markets are headed in the wrong direction? The problem with this view is that Fed Chairman Ben Bernanke does not believe it is his job to lead markets around by the nose like his predecessor. I think under the new regime, the Fed expects their comments to be taken at face value. And I think they are pretty effectively communicating their view on the economy: Outside of housing, there is minimal spillover, and whatever spillover exists is completely expected....

I do see Tim's point about Mr. Bernanke. But by the same token, Mr. Bernanke has to realize how his comments would be interpreted (in the October 15 speech to which Duy provides a link). If he didn't like it, there was time for him or others to refine the message.

If the Fed decides they are unwilling to defy the market, or that “risk management” requires additional rate cuts, I would have to conclude that regardless of what the statement says, that one must expect a series of multiple rate cuts. They will be responding to the deteriorating housing market, and I simply expect no stabilization in that market in the near future (don’t get me wrong – I am not a pie-in-the-sky optimist).

I know, and I've voiced my concern about this. But Tim is suggesting here that there is no way for them to issue a credible statement that really indicates that they are done. Obviously the September statement wasn't it. But I think it's possible to craft such a statement.

Bottom Line: I believe the Fed intended to take a pass in October with the 50bp rate cut. I believe market participants were correctly reading the data until they got caught up in the risk management story. I think the Fed has been explaining past actions, not future policy. For that, you need to look at their forecast. On the basis on the data alone, the Fed is already so far in front of the curve it is hard to justify another cut at this point. I absolutely do not expect the Fed to cut 50bp.

I also believe that they intended to hold rates constant now when they made their decision in September, and it is possible (likely?) that the risk management story got overblown. But I'm less convinced that they were explaining their past actions. I don't see them as being "far in front of the curve". I see them as wanting to get just a little bit below neutral. Given that potential growth may be slowing and inflation is mostly contained, they are probably not quite at neutral yet. I could accept another 25 b.p. as getting us close to where they want to be to end the year, or just a bit below. I think they would prefer to end the year at 4.5% as opposed to roiling the markets this week by throwing them a curveball.

Cut now, and make it clear that it's an early Christmas present and that they're not getting any more in December. Make it clear that at 4.5%, policy is neutral to slightly accommodative. I think they could sell that.

Tim and I agree on a couple things. A 50 b.p. cut is pretty much out of the question. He says he is mentally prepared to be wrong. So am I. But the more I look at the minutes of the last meeting, the Fedspeak, the continued uncertainty, and the general unease about growth prospects in the 3 to 9 month period ahead, the more I think that the decision to cut carries a bit less risk than the decision not to cut.

A thought occurs to me. The fact that we're having this last minute discussion about the possibility of no cut would, I believe, make it more credible for the Fed to announce that this week's cut (if there is one) is the last for a while.

Posted by William Polley at 10:30 PM | Comments (1) | TrackBack

Could the Fed hold rates constant?

Greg Ip, as always, has some of the keenest insight. In tomorrow's Wall St. Journal, he has a piece called "Why Rate Cut Isn't a Sure Thing."

Both courses of action have risks. Perhaps the biggest is that the market's certainty that rates will be cut creates a burden on the Fed to deliver. Ordinarily, meeting market expectations isn't a goal in itself for the Fed.

But the current environment is more fragile than usual, and thus the consequences of disappointing the market are potentially more damaging. Against that, the Fed will have to weigh the risk that a cut will stoke inflationary psychology.

I've been going back and forth on this in my head for the last week. My head would like to see a bold move to keep rates constant at this meeting and re-evaluate in December. My gut thinks that Mr. Bernanke will err on the side of caution. That we're even having this discussion indicates that there is much work to be done on the communication channels between the Fed and the market.

The bottom line for me is still that the Fedspeak leading up to the quiet period before the meeting was pointing to more downside risks. I took that to mean that they are leaning toward easing.

So let's think about how a "no cut" scenario plays out. The only way they can stand pat is to give a statement that opens the door to future cuts should intermeeting data turn sour. Given that GDP and payroll data is just around the corner and a long time from that data to the next meeting, I think there is a risk that holding steady now could potentially cause expectations of future cuts to get built into the market really soon after this meeting. I don't think they would find that to be optimal. Furthermore, I doubt that they could get a unanimous vote to hold steady. Again, the expectations of future cuts are sure to be built in from day one.

But if they cut on Wednesday and made a statement that credibly states that they are done for a while, I think that would be easier for the market to digest, and probably lead to a better result in the long run. Then in the intermeeting period they could clarify that they really are done unless things turn sour--and speak frankly about what it would take. They would have to state that they think that they are (75 b.p. lower than this summer) now ahead of the curve, that they need to stay vigilant with regard to long term inflation expectations, and that they have revised their growth forecast upward.

Door number 2 seems the likely choice. But it's not a sure thing.

C'mon folks! What do you think?

Posted by William Polley at 9:58 PM | Comments (0) | TrackBack

Thoughts on the Fed

Today's best article on the upcoming Fed meeting is in the Financial Times. Read and understand.

The Federal Reserve is likely to cut interest rates by a quarter-point to 4.5 per cent when its two-day policy meeting concludes on Wednesday. But the debate among Fed policymakers will be more finely balanced than is suggested by the odds in the futures market – in which a rate cut is seen as a virtual certainty.

According to anecdotal reports, there is some resistance among Fed insiders to the notion of a guaranteed rate cut. Many would have preferred to go into the meeting with market odds more evenly balanced, which would give the central bank greater latitude to make its determination without risking market turmoil.

It seems safe to say the Fed was not expecting to be in this situation when it cut rates by half a point in September. As Don Kohn, vice-chairman, explained shortly afterward, the Fed believed that by cutting rates more than expected it would get ahead of the curve.

The initial 50-basis-point cut was “a not unreasonable first approximation of what might be required to keep the economy on a sustainable path”, Mr Kohn said.

Indeed. Yet, some of the data that has come out since September has been worse than expected, particularly in the housing market. No need to rehash all of that here. We all know what has been going on. A sober assessment of the risks to the economy would have to include an increased recession risk since August and even since September. On that basis, it's hard to argue against a rate cut.

And yet, as an October cut has become more certain, it has also increased the likelihood that the market will expect future cuts. To feed into that belief would be a regrettable mistake. So how does the Fed tiptoe around this minefield?

First, they need to recognize that if there is going to be a housing induced recession, there is little that they can do about it short of refueling the housing boom, which is not an option. The cost of doing nothing may be slow growth for a couple of years. The cost of doing something may be a resurgence of inflation after a couple of years.

Higher oil prices and a lower dollar pose long term risks for inflation if the Fed is not careful. If the funds rate is below 4% in early 2008, I would become concerned about the inflation outlook going forward. They have to be very careful not to let expectations of inflation rise as that would just lead to more painful readjustments later.

The members of the FOMC know all of this very well, and I don't think they want a repeat of the last rate cutting cycle which went too deep for too long. And yet they will be tempted to yield to the siren's song. Ironically, it is less a matter of political pressure (as some say existed in the 1970s that led to inflation then) and more a matter of market pressure. Wall Street, not Pennsylvania Avenue, is addicted to the rate cuts. Even the scent of it in the air sends the Dow up these days. And as long as the Fed is worried about disappointing those who have made their bets at the Chicago Board of Trade, there is going to be a temptation to take the cuts too far. It's "measured pace" all over again but in the other direction. Remember how frustrated I was about that situation? I'm just as frustrated now. As wonderful as the fed funds futures market is, I'm sure that the inhabitants of the Eccles Building occasionally curse at it under their breath. That's why a communication policy revision is seriously in order.

Some kind of policy rule would really help. Because right now you have a situation where the market is guessing the Fed's next move and the Fed doesn't want to disappoint the market. Since market prognosticators are pretty bad at calling turning points, this makes it hard for the Fed to change direction. It's a setup for trouble, and is one of the better arguments for a policy rule such as an inflation target.

But since we don't have such a policy rule now, we will have to be content with simply wanting the Fed to make a statement that they are done for now, unless they aren't. As the FT article concludes:

More likely, policymakers will seek to balance a rate cut with a statement that tempers expectations of many more cuts to come. They will again hope they are done. But with economic uncertainty still high, they will want to leave open the option to cut again if necessary at the next meeting.

And you know what that means. We'll be having this same discussion again in a few weeks, unless they decide to send a signal that they are not beholden to the futures market and keep rates steady. As much as I might like the signal that it would send, it is an option that is not without risk. Perhaps a dissenting vote in favor of no cut could send the same message in a less risky way. I'm not convinced that the statement alone, no matter how strongly worded, would send the same message.

Marc Shivers thinks it will be 25 basis points as well. He bases this prediction off of the recent speeches by Fed officials. I've been reading those as well and I concur. Standing pat is a somewhat attractive option, and while a longshot, it seems more likely than 50 b.p. But ultimately, either extreme is too risky as it could roil the markets more than they want. If I were on the committee I would probably vote for no cut as long as I knew I would be in the minority. They will compromise on 25 b.p. and hope that they are done. (But I'd like them to prove me wrong by issuing a statement that really has some teeth.)

Posted by William Polley at 11:48 AM | Comments (0) | TrackBack

Fed meeting this week

I'll post my thoughts on the FOMC meeting later today. For now, read Greg Ip's piece in the Wall Street Journal.

Posted by William Polley at 12:53 AM | Comments (0) | TrackBack

October 25, 2007

Fed increasing transparency

Grep Ip writes in the Wall Street Journal:

WASHINGTON -- Federal Reserve officials are nearing consensus on several steps to make their deliberations more transparent to the public, but are likely to defer one of Chairman Ben Bernanke's longstanding goals: an explicit inflation target.

The centerpiece of their new communications steps would be the release of economic forecasts of policy makers four times a year, instead of the current two times, with additional detail and background, according to people familiar with the matter. Moreover, the horizon for those forecasts would be extended to three years from two.

Trying to set a target without really setting a target?

While the idea of setting an inflation target hasn't been shelved, officials say it needs more discussion. Meanwhile, they see the longer forecast horizon as an interim step with many of the benefits of an inflation target. The public could assume the Fed expects to achieve its desired inflation rate in three years and thus a third-year forecast amounts to a target. The forecast approach sidesteps the biggest problems with an official number: the misgivings some officials still have with a target, potential political fallout and the difficulty of agreeing on the right number.

...

At his nomination hearing in 2005, Mr. Bernanke restated his preference for a target while promising "extensive discussion and consultation" and "no precipitate steps." After he became chairman, he began making greater use of the FOMC forecasts to explain Fed policy. He also appointed Fed Vice Chairman Donald Kohn, like Mr. Greenspan a skeptic of targets, to head a subcommittee on communications. Mr. Kohn has shown signs of warming to the notion. In September, he said in a speech he was "relatively more persuaded" that targets help anchor the public's expectations of inflation.

Mr. Kohn is an important figure on the Board. If he comes around, there is a chance. But a big obstacle still remains at the other end of Constitution Avenue, and the committee is rightly cautious.

The FOMC as a whole is still not ready to take the step. One concern is that Congress, having taken a more populist turn since Democrats took power in 2006, could perceive a target as subordinating the Fed's responsibility for employment, despite Mr. Bernanke's insistence to the contrary. Another is that officials don't think the current system is broken.

No, it's not broken, but nor was it broken when many of the other steps toward transparency were taken. In principle, a target would certainly help to anchor expectations. And as a practical matter, a three year forecast might work as a reasonable proxy for an operational target even if nothing is written in stone. Additional releases of forecasts are surely welcome to any observers of the Fed out there.

I look forward to more of this.

Posted by William Polley at 9:55 AM | Comments (0) | TrackBack

October 5, 2007

111,000 Jobs in September: Good enough for Fed to hold?

Good, not great. That's how I'd sum up today's employment report.

Employment rose in September, and the unemployment rate was essentially unchanged at 4.7 percent, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. Nonfarm payroll employment rose by 110,000 following increases of 93,000 in July and 89,000 in August (as revised). In September, health care, food services, and professional and technical services continued to add jobs, while employment trended down in manufacturing and construction. Average hourly earnings rose by 7 cents, or 0.4 percent.

The unemployment rate actually climbed just a bit, but a 0.1% move in either direction is within the statistical margin. That said, it was 4.5% this summer, so that gives fuel to the argument that things have marginally deteriorated. Spencer was correct with his hypothesis that August numbers would be revised upward due to a fluke of timing in the data collection period. The last 3 months have clocked in at just under 100,000 per month on average.

That's no great shakes, but it's not recessionary yet. Opinions differ as to just how much job growth is needed per month to keep up with population growth. For a long time 150,000 was the number tossed around. Demographic changes have likely lowered that number, though probably not under 100,000. In casual conversation these days, I settle on around 125,000 and admit to uncertainty. In that respect, the recent numbers are good, but not great.

Given the current uncertainty about whether we are on the cusp of a recession, however, the numbers take on greater importance. Everyone wants to know whether this will move the Fed. No doubt this is a data point in favor of a less aggressive move, or perhaps no move at all. The Chicago Board of Trade binary options indicate that the probability of some kind of cut in October dropped from 56% to 41%. It's still pretty much a coin toss, but the bias of the coin shifted just a tad.

Then there was this speech today by Don Kohn. (h/t Calculated Risk) Here are a couple of salient points.

Many people had expected the Federal Reserve to follow a gradual path of rate reductions in response to financial market developments--say, 25 basis points in September and another 25 basis points in October. Such a path would be in keeping with how we have often approached our policy choices, as it has the advantage of allowing us to calibrate our policy as we see how the economic situation is evolving and responding to earlier policy moves. However, given the circumstances at the time of the September FOMC meeting, there were strong arguments in favor of the larger action of a 50 basis point decrease in the federal funds rate. For one thing, it seemed that a decrease of that size could well be necessary to promote moderate growth. We had been holding the federal funds rate at 5-1/4 percent, well above the expected rate of inflation, in part to compensate for what had been very narrow yield spreads and readily available credit. We did not know how quickly markets would recover, the extent to which credit terms and standards would be tightened, or precisely how households and businesses would respond to recent or forthcoming financial developments. But, pending further evidence, a 50 basis point easing was not an unreasonable first approximation of what might be required to keep the economy on a sustainable growth path.

In addition, I thought that economic performance would be better served by the Federal Reserve taking its chances on responding too much, or too rapidly, to the turmoil in financial markets rather than acting too little, or too slowly. Sluggish or inadequate easing risked a weaker real economy that might cause lenders to pull back even more, leading to a deteriorating situation that could prove difficult to reverse. With the news on inflation relatively favorable of late and with inflation expectations seemingly well anchored, I believed that we would be able to offset the cut in the federal funds rate--if it turned out to be larger than needed--in time to preserve price stability.

And what will become the headline for this speech...

We will need to be nimble in adjusting policy to promote growth and price stability.

That would seem to suggest a Fed that was ready to move decisively with an opening gambit of 50 basis points just in case all of it was needed. That doesn't mean that the next move will be that aggressive. Furthermore, they're ready to take it back if prices jump.

But right now inflation still seems contained. The CPI is up just 2% in the last year (that's the headline number, not core) and the most recent reading was actually a slight decrease. If the economy softens, it will keep the pressure off. But if not... then it pays to be nimble.

There is still a very large amount of sentiment for continued rate cuts, and today's employment number, while not entirely dismal, will probably not diminish that sentiment among those who hold most tightly to it. For those on the margin, it may be enough to urge them to wait. If the rest of the month's data turns out to be consistent with the labor data, then they may put off a cut until December. It seems to me right now that a further cut in October is speculative--an insurance policy in case the housing problems spill over into the broader economy. The more insurance they take, the greater the likelihood that they find themselves needing to reverse course in 2008.

For now, for my money, it's still a tossup.

In related action, PGL discusses the labor force participation rate and employment/population ratio. He mentions our discussion from way back. I'll say it again. The long run trends are for lower LFPR and E/P as the baby boomers retire. But that's not what we're seeing here. I raised the point then and repeat it now as a caution to not necessarily expect the "optimal" ratios today (and in years to come) to equal those of the late '90s. However, the declines over the last year (like the increases in the previous year) are of a more high frequency nature. PGL is correct to raise the issue. The decline in these numbers since December is indicative of some potential problems below the surface that deserve more investigation. More on that later.

Posted by William Polley at 3:38 PM | Comments (2) | TrackBack

October 2, 2007

Phelps on whether the Fed can prevent a recession

This just came in my inbox.

Sep. 27 (Bloomberg) -- Edmund Phelps, winner of the 2006 Nobel Prize for economics and a professor at Columbia University, talks with Bloomberg's Tom Keene from New York about limitations of U.S. Federal Reserve monetary policy, the role of central banks in preventing economic slowdown and risk facing the U.S. economy. (Source: Bloomberg)

I'll have to listen later. Time for class.

Posted by William Polley at 12:14 PM | Comments (0) | TrackBack

September 20, 2007

Just when I was almost convinced we're heading for recession, I see something like this

The Philly Fed is upbeat.

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

...

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

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

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

Posted by William Polley at 12:08 PM | Comments (1) | TrackBack

Bernanke speaks (and other assorted news)

Chairman Bernanke gave testimony to Congress on the subprime situation today. Read it on the Fed's newly redesigned website. The only mention of monetary policy is at the end, and it includes nothing new, only some quotes from the press release Tuesday.

In other related news, initial jobless claims were down, reaching their lowest level since July 28. This suggests that the employment report may have been a blip. Employment is somewhat of a lagging indicator, so don't get too worked up and thinking that the threat is over. More trouble could still be to come. Nevertheless, we'll take good news when we can get it. The Index of Leading Indicators, however, was down slightly.

Meanwhile, a certain former Fed chairman is enjoying his time in the spotlight. It is hard to get used to seeing Alan Greenspan all over the place talking to the media candidly, but get used to it we will. (Reuters)

Asked in an interview on Bloomberg television whether the Fed's half-percentage-point rate cut on Tuesday had lowered the chances of a recession, Greenspan said: "I think so, but remember that we still have a problem out there, which is a large overhang of unsold newly constructed homes."

...

Greenspan said the chances for a recession in the United States were still "somewhat more" than 1 out of 3, despite the cut in the Fed's overnight federal funds rate to 4.75 percent, but cautioned it was hard to be more precise.

"We are often wrong but never in doubt on too many issues," he said.

Indeed.

We're watching history unfold here, folks. The unwinding of the subprime mess is without precedent. But the monetary policy action has parallels in the past. Will this episode be more like 1998 (heading of systemic risk, short lived easing and a return to previous levels in a year) or like 2001 (the beginning of a series of cuts and the re-inflation of a bubble)?

To apply the wisdom of Greenspan, someone who doesn't have some doubt stands a good chance of being wrong.

Posted by William Polley at 9:48 AM | Comments (2) | TrackBack

Quite a day (Part II)

And so 50 basis points it shall be. Where do we go from here?

This was one of the most difficult Fed decisions to predict in recent memory. It was a bold move the Fed, and there are those who would disagree with it. A lot of us (Tim Duy and Barry Ritholtz, for example), myself included, were surprised. The market called it a toss-up. To my way of thinking, a 50 basis point move was a considerably less likely. I didn't put a probability on it, but I probably wouldn't have gone much over 20 or 30%. At least I was right that the move in the discount rate would match the cut in the funds rate and that they would not cut the discount any by an additional amount. But all that is ancient history now.

Perhaps a Q&A format would be a good way to organize my comments here. The questions are the things I've been hearing in the last day or so, and the answers are just my thoughts. You are free to agree or disagree (and comment).

Question 1: Did this move cost the Fed credibility?

Not as much as some think, but they did cash in some chips. The true cost to their credibility (or lack of cost) will not be known until we see the effect on inflation. The Fedspeak was not unambiguously pointing this way, but this wasn't totally out of the blue. Even those of us who were hoping for (and expecting) only 25 basis points were not shocked. We knew it was a possibility. Yet those of us who were hoping for 25 basis points were, I think, doing so on the basis that a larger rate cut isn't going to do as much good at preventing a spillover of the housing mess into the broader economy as it could do long term harm in the campaign against inflation. The Wall Street Journal is worried about their credibility too.

When I see a speech where a Fed official says this...

I believe disruptions in financial markets can be addressed using the tools available to the Federal Reserve without necessarily having to make a shift in the overall direction of monetary policy. A change in monetary policy would be required if the outlook for the economy changes in a way that is inconsistent with the Fed’s goals of price stability and maximum sustainable economic growth.

... it doesn't exactly scream out 50 basis points. So a 25 basis point cut certainly would have cost them less in the immediate run. Now, they are smart people, and they must have realized that. Yet they voted (unanimously, I might add) to do it anyway. That leads to the next question.

Question 2: Do they see something that we don't?

I anticipated this question back on the 10th. Clearly one of the risks to doing a 50 basis point cut is that people will think that it's worse out there than they thought (or worse than it is). But the answer to the question is, I believe, "no". To the extent that they see something we don't it could be that the inflation picture looks better than we thought. PPI and CPI data from the last couple days would support that claim. It's certainly too early to declare victory, but they may be hearing things from their contacts in the business community that allow them to take this position. But as for fighting a recession, if it has already begun, which it may well have, this isn't going to make much difference. So no, I don't think the see anything negative about growth that we don't already know.

Question 3: Is this "one-and-done"?

That is, did they figure that they could avoid the loss of credibility by making a larger cut now and then stop. Yeah, that's the question you want to have answered. Sorry to disappoint, but I can't say for sure. The fed funds futures market doesn't think so, however. They're looking for another 25, maybe 50 basis points, by the end of the year as December futures are implying a rate of 4.4%. If they want the market to believe that this is "one-and-done", they'll have to come out and say it because the message will not get through otherwise. If forced to make a guess right now, I would predict 25 basis points in October and December, but it's early and that's subject to change.

The problem I see is that in order for the Fed to hold steady, they are going to have to be able to state that the risk of a spillover from the housing market into the broader economy has materially diminished. I don't see how they'll be able to make that claim. A month from now the housing picture will not change much from what it is now.

Question 4: What are the downsides to this decision?

You saw the stock market reaction, right? You saw the double digit percentage gains among the homebuilders, right? You saw the price of gold, right? You saw this, right? Now, I don't always agree with Dean Baker, but in this post he is spot on 100%.

A bit of history would have been useful to include in this context. As some articles noted, this cut bears a resemblance to the Fed's 0.5 percentage point cut in January of 2001 at an unscheduled emergency meeting. That cut also led to a very enthusiastic response from Wall Street. The Dow rose 2.8 percent following that cut and the Nasdaq jumped by a record 14.2 percent. In reporting on the significance of the cut, the NYT quoted Bruce Steinberg, chief economist at Merrill Lynch: "there's a simple message, the Fed will do whatever it takes to keep the U.S. economy from going down the tubes.''

Mr. Steinberg may have been right about the Fed's intentions. It did continue to cut interest rates, lowering the federal funds rate by a total of 5.5 percentage points to 1.0 percent, the lowest rate since the mid-fifties. However, this rate cutting did not prevent the economy from falling into a recession. It began to lose jobs just a month after the January rate cut. In spite of the Fed's aggresive rate cutting,the economy remained so weak that it took four full years to once again reach the employment levels of February 2001.

The market may celebrate now, but this is fleeting. The punch bowl has been refilled, but you may have just made more work for the clean-up crew. Listen to Tim Duy, for example:

The Fed statement did claim that “some inflation risks remain,” but the concern rings hollow in the wake of a 50bp cut. Oil and gold gained on the news, while the Greenback sunk to a record low against the Euro before recovering. Were these, like the equity surge on Wall Street, just knee-jerk reactions? To some extent yes, but traders tend to get the direction right even if the magnitude is initially wrong.

He's not in the one-and-done camp either.

James Hamilton has this to say:

But the really interesting thing is what happened at the longer end of the yield curve. The ten-year nominal yield actually increased, which is in contrast to the usual historical pattern for long yields to move, albeit less dramatically, in tandem with the short. Taken together with today's fall in the 10-year inflation-adjusted Treasury yield, the bond market seems to view the Fed as having surrendered some on its long-run inflation goals.

Right. From the gallery in the CBOT, we watched it happen as the 10 year numbers went red and you just wanted to have a moment of silence for the passing of low inflation expectations. You teach this stuff for years, saying "this is what can happen..." and then it does.

I have to admit that the market reaction troubled me a bit. They didn't get the message. Or they got the wrong message. Or worse...they got it just right.

Question 5: Do I have anything good to say?

Yes. I am happy that the language of the statement does not appear to lock the Fed into any particular decision in October. True, I think they will continue to ease. However, I don't get that from the statement as much as I get it from the present circumstances. They will have a chance to move expectations, but the window will be open for only a short time. If they want to hold steady in October, they better get out there soon and communicate that, or it will be too late.

In fact, I think that the language of the statement was about as good as it gets for something like this. It was different, and fresh. We needed that.

The bottom line is that we'll have plenty to talk about for the next few weeks.

Posted by William Polley at 1:57 AM | Comments (2) | TrackBack

September 19, 2007

Quite a day (Part I)

I intended to post last night, but lack of sleep got the better of me. Anyway, the reason that I was away from the computer yesterday is that two other economics faculty and I took a group of econ majors, graduate students, and other interested folks up to the Chicago Board of Trade yesterday to watch what happened on the floor when the Fed announcement came out. Astute readers will recall this post from a few weeks ago:

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

The blog is great for keeping some of those notes to self in writing so they can be remembered and acted upon.

Let me also say that I am very happy to be part of a department that places such value on these kinds of experiences for students.

Last spring we saw the Board of Trade on a day where there was considerable activity in the grain markets, but the financial markets were absolutely dead. There were just a few people milling around checking the computer screens, reading the newspaper, and so forth.

Contrast that with yesterday. In the gallery there was a map showing what instruments are traded in each pit. It appeared that the most activity was in the bond futures and options, particularly the 10 year, but a bit of activity in the 2 and 5 year as well. There were some people in what the map showed was the fed funds pit, but the activity was not frantic. My guess is that a lot of that activity is electronic. There was some activity in the Dow futures, more on that later.

We got up to the gallery shortly before 1:15 as traders were quietly waiting for the announcement. I was looking at the bond options area when I heard a noticeable rise in volume from the floor. That's when I turned to the big CNBC monitor in the corner and saw that the announcement had come out and that it was 50 basis points. Within seconds, the pace of activity had increased from relative calm to a rather brisk pace. Yet it was controlled rather than frantic. I would guess that every trader on that floor had a game plan for this possibility that they had thought out ahead of time. They were executing that game plan rather than simply reacting. Had the decision been for 25 basis points, the game plan would have been different, but it would have been similarly executed.

Casual observation: There was some media coverage on the floor. I could see the cameras but from my vantage point I could not see the reporters. It looked like CNBC cut to their camera on the floor a couple times while we were there, and when it did the volume level on the floor seemed to rise. (Playing to the camera?)

Prices of various instruments were posting up to the big digital boards on the wall. Green numbers under the 2 year note futures, red numbers for the 10 year futures reflecting the movements taking place on Wall Street as the short term prices rose (yields fell) and the news was mildly negative for the longer term bonds. As someone who takes an interest in this and teaches it, I have to say that it was quite a sight to see those the hand signals in the pit and look up and see the numbers on the board go red and green as the traders digested the information.

Another way that the trading in Chicago mirrored that on Wall Street was in the Dow futures. Again, we could see on the digital price board that the DJIA was heading upward while all of this was going on. It was up about 170 points at the point when I started to notice what was going on with the futures. Every few minutes there was a little outburst of activity in the futures. As the Dow climbed, the futures kept pace. The September contract expires on Friday, and of course other months prices rose in lock step (this is where you can illustrate the law of iterated expectations).

All told, it was a great day for the students to see economics and finance in action. Before the announcement, we even got to go down to the trading floor briefly as a guest of a trader who knew one of our students. Also that morning, before going to the CBOT, we visited a consulting firm. That gave our students a chance to see more about how economics is used in the "real world". Now I'm working on a handout and presentation as a "debriefing" for the students to reinforce what they learned. I think the title of the presentation will be "What happened while you were watching and why?".

We also got to meet up with a student of ours who just finished an internship in Chicago and leaves next week for a study abroad term at Oxford. Did I tell you that our students can compete with the best?

Later, some thoughts on the rate decision itself.

Posted by William Polley at 11:12 AM | Comments (0) | TrackBack

September 18, 2007

Some links to keep you occupied until the big announcement

I've got to get some sleep. I'm going to be pretty busy tomorrow (today, actually). More about that later. For now, Mark Thoma has some posts that are worth looking at. First, he reminds us, via Greg Ip, that the discount rate could be cut (or not) tomorrow as well. We haven't given as much time to that. My own guess is that they will cut the discount rate by as much as the fed funds target. There's an outside chance of a 50 b.p. cut if the funds rate is only cut by 25 b.p., but I'd regard that as less likely. 25 b.p for both seems most likely.

Next, Mark offers an idea to increase transparency.

Here's an idea for additional transparency into Fed thinking. Suppose we require that each of the twelve members of the Federal Open Market Committee (the committee that sets the federal funds rate) post their stance on monetary policy once per day on a central web site.

On the Fed's main web site there would be a page listing each Committee member's answer to the question "If I had to set the federal funds rate today, I would set it at ____" and a table would list all twelve answers along with the last time the answer was updated, Committee members would be required to update their answer at least once per day, even if there is no change, and they could update it more often if desired, e.g. in response to news about the economy (the basic unit of time could be weekly as well). It would probably be best if the votes were anonymous, but that isn't essential.

I have my doubts. There's a nontrivial chance that such a plan would destabilize the market. I mean just imagine how much more volatile futures contracts would be if they were responding to actual forward looking statements about the vote from the members themselves. Then there's the matter of credibility. How would the market interpret frequent changes in sentiment? How would they interpret a sudden reversal, or double reversal? I, for one, am glad that the voting members weren't giving us a day-by-day update on their vote. I don't think it would be helpful to have that play out on a daily basis, especially during a time of crisis. If things get bad enough, have an intermeeting cut. If not, then send the signals through fedspeak and retain some flexibility.

If you want more transparency and accountability, go for an inflation target. Then you might get a little more stability to boot.

As for those futures contracts, Mark does the reporting on that as well. We seem to have settled on 50-50 between a 25 b.p. and 50 b.p. cut.

That's all for now. I'll post in the evening and tell you about what kept me busy.

Posted by William Polley at 12:53 AM | Comments (4) | TrackBack

September 17, 2007

We're not used to such clarity from him

Former Fed Chairman Alan Greenspan has left the obfuscations of Fedspeak behind him. Now he comes right out and tells it like it is. Mr. Bernanke can't be too happy about this one:

WASHINGTON (Reuters) - Former Federal Reserve Chairman Alan Greenspan said in an interview published on Monday the Fed would have to raise interest rates to double-digit levels in coming years to thwart inflation.

Yikes!

Well, anything is possible, but this one isn't too likely in my book in the near future. But then again, Greenspan is probably looking out future ahead than the next easing and tightening schedule--ahead to a time when China may be looking at runaway money growth and exporting inflation to the rest of the world. Impossible, you say? Well... (Wall St. Journal)

BEIJING -- China raised benchmark interest rates late Friday as it stepped up efforts to damp accelerating inflation, and analysts predicted the central bank's fifth rate increase this year won't be its last.

Fueling the need to raise rates is an economy that expanded 11.9% in the second quarter and shows no signs of slowing. Data released last week showed continued strong growth in money supply and investment spending.

How do you look at that situation and not get concerned? We talk about soft landings. They're riding a rocket. How do you pull off a soft landing that way?

Anyway, today is the calm before the storm. I'll be busy, so posting will be light unless something exciting happens today. Besides, if you've been reading the blog for a while you know what I'm thinking. It's not how I would have wanted to see things go, but I think a 25 b.p. cut is the most likely outcome. Ultimately, the inflation cost of one 25 b.p. cut is probably not that large right now. An honest case can be made that a cut will soften the blow should things turn downward this fall. However, 50 b.p. would be a mistake, IMHO. That does not mean that it can't happen.

I will not be posting until late on Tuesday, but I will have something whatever the result.

Posted by William Polley at 1:19 AM | Comments (1) | TrackBack

September 14, 2007

Meltzer to Fed: "Don't be afraid to disappoint the market."

Allan Meltzer writes in the Wall St. Journal:

With annual inflation at 2% or more and unit labor costs rising at a 5% rate, loose fed policy risks reviving the latent fears that it is willing to permit higher inflation now to respond to a forecast that unemployment may rise. That returns to the policy that made the Great Inflation costly and durable.

The better policy is to wait until the very mixed data of the moment forms a pattern. High-frequency data is often revised. It often has transitory aberrations that do not persist. Unfortunately, after a major change in underlying conditions, we know even less than usual about the future.

86 hours to go.

Posted by William Polley at 11:10 PM | Comments (1) | TrackBack

September 13, 2007

Greenspan's mea culpa

Alan Greenspan is quoted in the NY Times

“While I was aware a lot of these practices were going on, I had no notion of how significant they had become until very late,” he said in an interview to be broadcast Sunday on CBS’ “60 Minutes.” ”I really didn’t get it until very late in 2005 and 2006.”

Set your DVRs. His book comes out on Monday.

UPDATE: The book was scheduled to be released on Monday. Apparently someone didn't get the memo. The Wall Street Journal went shopping...

The book is scheduled for public release Monday. The Wall Street Journal bought a copy at a bookstore in the New York area.

And thus, journalistically, it is fair game.

Many economists say the Fed, by cutting short-term interest rates to 1% in mid-2003 and keeping them there for a year, helped foster a housing bubble that is now bursting. In his book, which was largely written before much of the recent turmoil in credit markets, Mr. Greenspan defends the policy. "We wanted to shut down the possibility of corrosive deflation," he writes. "We were willing to chance that by cutting rates we might foster a bubble, an inflationary boom of some sort, which we would subsequently have to address....It was a decision done right."

So he admits to 60 Minutes that he "didn't get it" when it came to the subprime debacle, but he defends the the decision to keep rates low.

Can't wait to see the interview and read the book.

Best line from the article:

Mr. Greenspan recalls his amazement when an adviser to Russian President Vladimir Putin asks him to discuss Ayn Rand, the libertarian philosopher with whom Mr. Greenspan had been friends.

Wish I could have heard that conversation.

Mark Thoma and Felix Salmon have much more.

Posted by William Polley at 7:56 PM | Comments (1) | TrackBack

September 10, 2007

Some links to start your week

By now you have probably heard about the speech given by Charles Plosser. Read it. It is destined to be a classic as it is an extremely candid recounting of the events of the last few weeks from an "inside the Fed" perspective. The speech itself clearly shows that Plosser is reluctant to cut rates on the 18th. In an interview afterwards, he makes it crystal clear. (Bloomberg)

"We want to be careful not to overweight one piece of information,'' he said in an interview late yesterday after a speech in Waikoloa, Hawaii. "I've not made up my mind at all'' on whether a rate cut is needed, he said.

Tim Duy doubts that the expected cut on the 18th will be the only one. Unfortunately, they might be in a lose-lose situation. If they cut only 25b.p., people will expect more. If they cut 50b.p., people will infer that it's worse out there than they thought... and thus they will expect more. Knzn has more to say about why he wants 50b.p. I'm still expecting just 25b.p. and even that is causing me a lot of internal struggle. I'm basically in the camp with Plosser and Poole, and if you read the last line of Tim Duy's post, you'll know why.

I was listening to Bob Brinker's Money Talk on the radio this weekend. He says that the Fed is being dragged into this "kicking and screaming." Brinker says the Fed is behind the curve... a statement that neither Duy nor I would agree with. But he's right about the kicking and screaming part.

Finally, I found a brand new blog while ego-surfing this weekend. It will be entirely based on Fedspeak. It's by Marc Shivers and it's called "The Talking Fed." Check it out.

Happy Monday!

Posted by William Polley at 12:10 AM | Comments (1) | TrackBack

September 7, 2007

Nonfarm payrolls fall for first time since 2003

Not good. Nonfarm payrolls fell by 4000 workers--given that revisions can be substantially larger than this, we can just say that it is flat. And flat is not good at all.

Here's something out of the report that highlights the even softer underbelly of this already soft report:

The number of persons employed part time for economic reasons, at 4.5 million in August, was 359,000 higher than a year earlier. This category includes persons who indicated that they would like to work full time but were working part time because their hours had been cut back or because they were unable to find full-time jobs.

That's roughly an 8% jump in the number of people employed part time for economic reasons since last year. Hard to put a positive spin on that.

As usual, PGL at Angry Bear reports on the employment to population ratio and the labor force participation rate.

How does this affect the outlook for the FOMC meeting? Glad you asked. The CBOT binary options now put a 93% probability on at least a 25 basis point cut and now a 60% probability on at least a 50 basis point cut.

The market is now firmly, solidly, and perhaps irrevocably convinced.

And it is hard to argue with it. All along this path, I have argued that it would take genuine weakness in the economy to push the Fed off its trajectory. As we went through spring and summer many observers, myself included, became more convinced that the strong 2nd quarter GDP figures may be the last gasp before significantly slower growth in the 3rd and 4th quarter. Recession probabilities are higher. Given that the labor market is lags the overall economy slightly, it is possible that in hindsight we will look back and say that at this point a recession had already begun. While I still think it is premature to make that call, it would be wrong to ignore the possibility.

Just in case you don't have enough to worry about already, listen to what Michael Mandel has to say.

If you are worrying about the economy, don't start with the weak job report--start with yesterday's productivity report. Nonfarm productivity has only risen by 0.9% over the past year. The four-quarter average of nonfarm productivity has only risen by 0.5%, the smallest increase since 1995.

Productivity growth establishes the sustainable growth rate of the economy. The fact that productivity growth is so slow has two consequences. One, it means that the economy is much more vulnerable to shocks that can push it into recession. Second, it puts Bernanke into a bind...with productivity slow, he has to be much more worried about inflation.

It is the latter consequence, the inflation threat, which weighs over Chairman Bernanke's head as they go into the meeting. While it is unlikely that a single rate cut this month would significantly increase inflation, the Fed needs to be very careful about what they communicate about where they will go from here. In 1998, the Fed cut three times and didn't remove the accommodation for almost a year. Some say that contributed to the end game of the bubble and bust of the dot coms in 1999 and 2000. An analysis of that episode and its lessons for today could spawn many essays.

And so we go into this weekend under the expectation that a rate cut on the 18th is almost a foregone conclusion. And that means it's time to start thinking seriously about October, which is not a foregone conclusion yet. We'll see a lot of data between now and then. Lots of things to think about.

For the 18th, a 25 basis point cut with the risks weighted equally towards lower growth and higher inflation would acknowledge what is happening without locking them into anything for the next meeting. It is imperative that they not lock themselves into anything for October. I have less objection to a 25 basis point cut if it is understood that it is NOT the first in a sequence. If it is interpreted as the first in a sequence, that will only lead to problems later.

Posted by William Polley at 2:51 PM | Comments (5) | TrackBack

Fed speeches

Of course, it's not just the speeches of Fed officials that are so interesting, but the Q&A afterwards can give real insights. Bloomberg has the summary from Thursday.

Sept. 6 (Bloomberg) -- Four regional Federal Reserve bank presidents declined to endorse a cut in the benchmark interest rate this month, as policy makers gauge the impact of the credit-market rout on the U.S. economy.

Did anyone expect them to?

Kansas City Fed President Thomas Hoenig and Dennis Lockhart of the Atlanta Fed said they hadn't seen sure signs of a housing spillover into the broader economy. St. Louis Fed President William Poole and the Dallas Fed's Richard Fisher said the effects of the turmoil so far are unclear.

The comments suggest some Fed officials may need more convincing before deciding to lower the main U.S. interest rate for the first time in four years when they meet Sept. 18. Most economists and investors expect the Fed to reduce the rate at least a quarter point from the current 5.25 percent to contain economic risks from housing and subprime-loan fallout.

Hoenig and Poole are voting members, for what it's worth. Further down the article...

Lockhart, 60, making his first speech on the economic outlook since succeeding Jack Guynn in March, said in Atlanta that "so far, I have not seen hard or soft data that provide conclusive signs that housing problems are spilling over into the broad economy.'' He cited "real-time information'' from regional business contacts.

Poole, speaking in London, said the Fed will not be "pushed into a decision.''

That's a bold statement. It looks to me like a number of committee members, including Chairman Bernanke, do not want to cut the fed funds rate eleven days from now. But what if they do vote to cut the funds rate? Am I to infer that something has changed from what I'm hearing in these speeches? Or am I to infer that they were pushed into it? This post on the Wall Street Journal's MarketBeat giving five reasons that the Fed will cut rates reminds me that we're not all on the same wavelength here.

The market is expecting it. Federal-funds futures contracts traded on CME Group are still pricing in a 100% guarantee that the Fed will cut rates on Sept. 18. While the Fed isn’t one to necessarily respond to bile-spewing yahoos on television demanding rate cuts, it isn’t in the habit of ignoring the market as a practice. According to Bianco Research, in 29 of the last 30 Fed meetings, by this time (10 trading days before the meeting), the futures contracts were accurately forecasting what the Fed planned on doing.

Yes, but 29 out of the last 30 meetings have been really easy calls. (I believe the meeting after Hurricane Katrina might be the odd one out, but I'm not positive.) This is, I think, the first time in several years that we're this close to a meeting and I don't have more than an 80 or 90 percent confidence in the way things are going to go. So with regards to Bianco Research, I'd say that past performance is no guarantee of future results. And while CME futures might be more certain, the CBOT binary options are still at "just" a 75% probability of a cut.

For his part, Barry Ritholtz says that this is irrelevant. And of course, if you've been following the general tone of my posts for the last few weeks, you know that on this point, I am predisposed to agree with Barry, and with Poole. They're not going to be pushed into this. And yet... I still acknowledge that a cut is possible if, say, their real-time contacts start to turn at the last minute or if we get a flare up of the problems experienced in August.

So how can I help but worry a little about how this decision (whichever way it goes) will affect the Fed's credibility and the market's perception of their communication strategy going forward? In a perfect world, the meeting would be a week or so later, so that they would have another week to get their communication strategy together and put some distance between the August meltdown and the meeting. Unfortunately, that is not an option.

Back to the Bloomberg article one more time...

Lockhart said the Fed's current challenge is to balance three concerns: responding to economic risks, preserving gains against inflation and keeping the financial system stable. His comments indicate he may not yet see a reason to lower interest rates, as most economists and investors anticipate the Fed will do this month. Lockhart starts voting on rates in 2009.

"Current readings of inflation represent progress, but not victory,'' Lockhart said, voicing concerns that Bernanke omitted from his last speech. "I would like to see inflation sustained at a somewhat lower rate -- with emphasis on 'sustained.' If inflation is allowed to accelerate, bringing it back down will be costly and painful.''

That's the same mantra you might have heard a year ago. And so it goes.

In other news, the ECB kept their rates constant yesterday. A few weeks ago, everyone was expecting an increase. Why do I bring this up? If the Fed does cut rates, it would preserve the spread between U.S. and European interest rates that would have been expected a few weeks ago. That's not a reason to cut, but it would suggest that the impact of a cut on the dollar would be muted somewhat. The implications of keeping rates steady given the ECB decision are left as an exercise to the reader.

Later this morning... the August employment report, and perhaps a baby step towards some resolution of uncertainty. Or not.

Posted by William Polley at 12:35 AM | Comments (2) | TrackBack

September 5, 2007

Beige Book

The latest Beige Book is out, and it will not add any fuel to the fires of those expecting a rate cut.

Here's how it begins...

Reports from the Federal Reserve Districts indicate that economic activity has continued to expand. St. Louis and Kansas City described the pace of activity as moderate; Cleveland, Chicago and Minneapolis said their economies were expanding at a modest rate; and Boston and Atlanta reported that activity was mixed. New York cited continued expansion. The economies in Philadelphia, Richmond, Dallas, and San Francisco continued to grow; however, the pace of activity has slowed.

Most Banks reported that the recent developments in financial markets had led to tighter lending standards for residential mortgages, which was having a noticeable effect on housing activity, and several noted that the reduction in credit availability added to uncertainty about when the housing market might turn around. While several Banks noted that commercial real estate markets had also experienced somewhat tighter credit conditions, a number commented that credit availability and credit quality remained good for most consumer and business borrowers. Outside of real estate, reports that the turmoil in financial markets had affected economic activity during the survey period were limited.

In calculus terms, we might say that the first derivative of GDP is still positive, but the second derivative is negative. It's at times like this when honest minds can disagree about whether a rate cut really is warranted. But overall, the Beige Book does not lend a tremendous amount of support to those wanting a rate cut. Nor will it change very many minds of those who want a rate cut. In that sense, it's not much that we didn't know. However, it is very important to consider how this will affect those who will actually be voting at the FOMC meeting in a couple weeks. Given that Chairman Bernanke recently stated that the Fed would be closely watching the incoming data, this would lead one to expect that the Chairman and those in his camp will see this as justification for holding the line for at least one more meeting.

That certainly seems like a reasonable interpretation, and if you read Reuters, you'd be led to the same conclusion.

NEW YORK (Reuters) - Stocks added to losses on Wednesday after the Federal Reserve's Beige Book summary of economic conditions suggested continued strength in the economy, reducing expectations for an interest rate cut.

Yet, the traders at the Chicago Board of Trade aren't buying it. 30 day fed funds and the binary options haven't budged.

There should be some interesting Fedspeak in the next few days. Maybe that will give us more clues.

The Wall Street Journal Real Time Economics Blog has more quotes from the Beige Book

Posted by William Polley at 2:26 PM | Comments (0) | TrackBack

Edward Gramlich, Former Federal Reserve Governor, 1939-2007

Edward "Ned" Gramlich, who warned of the consequences of lax standards in the banking sector while a governor at the Federal Reserve, has passed away at the age of 68.

From a Bloomberg article on Gramlich today:

"Sometimes one's advice must be weighted toward economic practicality, sometimes toward humanity,'' Gramlich told the Senate Banking Committee. "A good economist should know how to balance both objectives.''

By that measure, Ned Gramlich was a "good economist".

Here are some of the links to articles reporting on Gramlich's passing.

Wall Street Journal

Months ago Mr. Gramlich agreed to give a luncheon address at the Federal Reserve Bank of Kansas City's annual symposium in Jackson Hole, Wyo. Since he was too sick to attend, his prepared remarks were delivered Friday by David Wilcox, deputy director of research at the Fed. Mr. Wilcox, before delivering the remarks, said he and the rest of the staff felt a special bond to Mr. Gramlich because he had been a staff economist there in the 1960s. Mr. Gramlich found "it perfectly natural to treat us all truly as colleagues when he returned as a governor."

Reuters
Forbes
Washington Post
Statement from Federal Reserve Chairman Ben Bernanke
Urban Institute Press Release

Posted by William Polley at 1:49 PM | Comments (0) | TrackBack

August 31, 2007

Bush addresses subprime lending

Via Reuters:

The FHA will soon launch a new program called "FHA Secure" to allow homeowners with good credit history, but who cannot afford their current payments, to refinance into FHA-insured mortgages, Bush said.

"This means that many families who are struggling now will be able to refinance their loans, meet their monthly payments and keep their homes," he said.

For the cynical take, see The Big Picture. Tanta at Calculated Risk is "underwhelmed". Looks like sound and fury to me...not sure it signifies very much.

Posted by William Polley at 12:31 PM | Comments (0) | TrackBack

Bernanke at Jackson Hole

Here is a link to the much anticipated speech by Fed Chairman Ben Bernanke today at Jackson Hole. And here's the money quote that everyone will be reporting...

Well-functioning financial markets are essential for a prosperous economy. As the nation's central bank, the Federal Reserve seeks to promote general financial stability and to help to ensure that financial markets function in an orderly manner. In response to the developments in the financial markets in the period following the FOMC meeting, the Federal Reserve provided reserves to address unusual strains in money markets. On August 17, the Federal Reserve Board announced a cut in the discount rate of 50 basis points and adjustments in the Reserve Banks' usual discount window practices to facilitate the provision of term financing for as long as thirty days, renewable by the borrower. The Federal Reserve also took a number of supplemental actions, such as cutting the fee charged for lending Treasury securities. The purpose of the discount window actions was to assure depositories of the ready availability of a backstop source of liquidity. Even if banks find that borrowing from the discount window is not immediately necessary, the knowledge that liquidity is available should help alleviate concerns about funding that might otherwise constrain depositories from extending credit or making markets. The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets.

It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy. In a statement issued simultaneously with the discount window announcement, the FOMC indicated that the deterioration in financial market conditions and the tightening of credit since its August 7 meeting had appreciably increased the downside risks to growth. In particular, the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally.

The incoming data indicate that the economy continued to expand at a moderate pace into the summer, despite the sharp correction in the housing sector. However, in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country. Inevitably, the uncertainty surrounding the outlook will be greater than normal, presenting a challenge to policymakers to manage the risks to their growth and price stability objectives. The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.

The rest of the speech is mostly a history of the housing and mortgage markets from the turn of the 20th century onward. It is really quite interesting, and I would recommend that anyone who teaches money and banking put it on their reading list.

Toward the end, this caught my attention:

The dramatic changes in mortgage finance that I have described appear to have significantly affected the role of housing in the monetary transmission mechanism. Importantly, the easing of some traditional institutional and regulatory frictions seems to have reduced the sensitivity of residential construction to monetary policy, so that housing is no longer so central to monetary transmission as it was. In particular, in the absence of Reg Q ceilings on deposit rates and with a much-reduced role for deposits as a source of housing finance, the availability of mortgage credit today is generally less dependent on conditions in short-term money markets, where the central bank operates most directly.

Most estimates suggest that, because of the reduced sensitivity of housing to short-term interest rates, the response of the economy to a given change in the federal funds rate is modestly smaller and more balanced across sectors than in the past. These results are embodied in the Federal Reserve's large econometric model of the economy, which implies that only about 14 percent of the overall response of output to monetary policy is now attributable to movements in residential investment, in contrast to the model's estimate of 25 percent or so under what I have called the New Deal system.

This struck me as a very subtle way to communicate two important ideas. First, the real estate market is less synchronized with the business cycle than it used to be, and second, the fed funds rate is not the best tool for addressing problems in the real estate market. I agree with both, and if that is the operational view of the FOMC, then that anticipated rate cut on the 18th becomes a little bit less of a sure thing.

Bernanke concludes by acknowledging Edward (Ned) Gramlich, whose illness prevented him from attending the Jackson Hole symposium. You can buy Gramlich's book on the subprime debacle on Amazon. Watch it on BookTV this weekend. Keep the Gramlich family in your thoughts and prayers.

Posted by William Polley at 11:55 AM | Comments (1) | TrackBack

August 29, 2007

Fed funds market is looking more normal

After a rather wild few days discussed here, the fed funds market appears to be settling down. The standard deviation of fed funds trades is a small fraction of what it was during the height of the liquidity crisis, and the weighted average (effective) fed funds rate is pretty close to the target (data). Calculated Risk has some charts.

There was no "stealth cut". What we saw was a function of a few very low trades when the Fed injected large amounts of liquidity. The injections were large enough so that at the margin its value was zero--and it was priced accordingly. (Micro level data on this would probably be quite illuminating, but I don't believe it is publicly available.) That's not a bad thing to do when people are in the state that they were in. But now that portfolios have adjusted and cooler heads are prevailing, they've removed the slack. Back to, mostly, business as usual.

And there were no real surprises in the minutes from the last FOMC meeting, nicely summarized by the Wall St. Journal. Yes, they acknowledged the possibility that policy action might be necessary if the worsening financial conditions threaten economic growth. Yesterday's consumer confidence numbers notwithstanding, it is not yet clear that we are at that stage. The possibility of a rate cut before the end of the year is not out of the question. But a cut on September 18 is not a foregone conclusion. CBOT Binary Fed Options are saying it's about 2 to 1 odds that they will ease.

But with the meeting three weeks away, you can be sure that a number of events will cause those odds to fluctuate a bit before (maybe) converging toward something we can (almost) count on. Stay tuned.

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August 22, 2007

David Wessel has a first-rate column in the Wall Street Journal today

Tomorrow, actually, as I write this... but in any case...

It seems these days that economists and pundits (myself included) are full of analogies. Here's a good one from David Wessel in the Wall Street Journal.

Think of the nation's economy as an automobile that requires gasoline for power (loans to businesses and consumers) and oil for lubrication (short-term credit among financial players.)

The immediate problem isn't gasoline: Banks are strong, and corporate coffers are full of cash to invest. The problem is lubrication. Countrywide Financial makes mortgages and then sells most of them to investors within weeks, but it needs short-term financing for that interval. It relied on short-term IOUs known as commercial paper but is having trouble selling that paper now.

It's worth your time to read the whole thing. He sums up in one column a lot of things that have been said in a lot of places over the last few weeks about how the financial system has changed since the crises of years past.

Posted by William Polley at 11:30 PM | Comments (2) | TrackBack

Why did the four large banks borrow from the Fed?

The NY Times reports:

With the four largest U.S. banks and a major international bank having borrowed from the Fed through the central bank's discount window, others may be more willing to follow, analysts said.

"The psychology is, if a bank needs to borrow from the discount window, and they think there's a stigma attached to it, they can say, 'Citi has done it, too,"' said Robert Albertson, chief strategist at Sandler O'Neill in New York.

Tyler Cowen cleverly responds:

Imagine that you, as a smart person, went around saying stupid things, in an attempt to limit discrimination against the stupid. You can come up with other analogies of your own.

That's true up to a point. But there's also the fact that no single one of those banks would have wanted to do it alone. No one wanted to be the first to the buffet table with the whole room watching, so the host gently nudged some good friends to go up together. Plus, the banks' motivation is not as altruistic as Tyler's analogy would suggest.

In other news today, Bank of America announced that it was buying a $2 billion equity stake in Countrywide. (NY Times)

Under terms of the deal, Bank of America, based in Charlotte, N.C., acquired $2 billion in the form of nonvoting, convertible preferred stock yielding 7.25 percent annually, Countrywide said.

Let's be clear. Bank of America isn't financing this deal (or even part of it) with borrowed reserves that need to be paid back in 30 days. This is more of a long term decision. However it is interesting that these events happened on the same day. Interesting in the sense that it reaffirms my belief that these four banks, of which Bank of America is one, are not borrowing from the Fed because they are in trouble. King Banaian (SCSU Scholars) agrees and writes

I'm reminded of the Knickerbocker crisis of 1907, when NYC banks did act as a lender of last resort before there was a Fed.

They are trying to show their confidence in the system. How far that will go remains to be seen. Whether others will follow also remains to be seen. But let's remember too that J.P. Morgan didn't organize the 1907 rescue of the banks out of charity. And in the movie It's a Wonderful Life, Potter wasn't selling, Potter was buying. We need to remember that the four banks that borrowed aren't doing something for nothing. They simply didn't want to do it alone. Perhaps today there are no Morgans and no Potters who can do it alone, and perhaps that's a good thing. There's liquidity out there. It just needs to keep circulating. Both of today's tangentially related events show that it is possible.

And that is a good thing.

Posted by William Polley at 9:52 PM | Comments (1) | TrackBack

The jawboning appears to be working

From today's NY Times:

Fed officials and top Treasury officials continued on Tuesday to talk by telephone with major banks, encouraging them to borrow from the discount window and repeating that there was no stigma associated with such loans. Traditionally, banks have only resorted to the Fed’s discount window when they had no other place to borrow money.

And Reuters now reports (ticker symbols and links removed)

NEW YORK (Reuters) - The four largest U.S. banks, led by Citigroup and Bank of America Corp. took the unusual step of borrowing $2 billion directly from the Federal Reserve on Wednesday, as the Fed tries to stabilize tempestuous financial markets by adding money to the banking system.

U.S. shares rose after the move, but financial stocks declined slightly.

Borrowing money directly from the Fed is usually seen as a sign of weakness, but JPMorgan Chase & Co., Bank of America and Wachovia Corp., said they have ample access to funds and made the move for the sake of the financial system. Citigroup, meanwhile, said it borrowed funds for customers; but the bank has issued at least $2.5 billion of corporate bonds this month.

The Wall Street Journal also carries a story and adds that the borrowing was $500 million by each bank.

It is important to point out that the stigma associated with discount window borrowing is largely a holdover from the days when it really was a discount. And so even today, there is still a reluctance among banks to go to the discount window that goes beyond the fact that now it is above the fed funds target. An excerpt from this Reuters story shows that people haven't totally figured out how to handle this. Again, the reference is to the four major banks stepping up to the window in what was obviously a coordinated move.

Analysts said the move could be encouraging for the market after the Fed said that using its discount window would be considered a sign of strength.

"I'm not sure if it's positive or negative. (But) if there are no problems, then they wouldn't have to borrow, so that could raise a flag," said Steve Goldman, market strategist, Weeden & Co. in Greenwich, Connecticut.

I think it's positive, and here's why. The coordinated nature of the move is meant to inspire confidence. They are not doing this because they had to do it today--and this is why it is important that the term of the discount window loans has been extended to 30 days as well. These four banks just took out a total of $2 billion in reserves over and above what they need. They will now be able to extend short term credit to their clients at nearly the same rate. There is still likely to be some small cost to the banks, so this isn't something that one of them would do themselves unless they had been on the receiving end of those phone calls from the Fed and the Treasury.

But this is going to allow some additional liquidity to circulate privately for a few weeks to help arrange for a more orderly workout of the situation. The four banks benefit from that just as everyone else does. Everyone needs to take a step back and see that this is exactly the sort of thing we've been hoping for.

It looks as if a lot of market participants are in a position where they are not yet ready to go to the lender of last resort, but they are feeling squeezed nonetheless. And this is throwing sand in the gears of the system. The Fed is the lender of last resort, but what can they do if troubled institutions are not yet at the panic stage where they need the Fed's emergency help.

They do exactly what they have done. They extend credit to institutions at the top of the private credit structure and encourage (jawboning or moral suasion) them to act as the "lender of next-to-last resort". In so doing they reaffirm that this is not an interest rate problem but a liquidity problem. This looks like a very encouraging development, and I wouldn't be surprised to see more of it in the coming weeks. Though some see this as a precursor to a cut in the funds rate, I do not. I see it as been an attempt to stave off a rate cut unless these problems affect the broader economy. If this plan works as they want it to, it is more likely to be contained and thus the need for a rate cut is decreased.

Posted by William Polley at 1:05 PM | Comments (1) | TrackBack

August 20, 2007

A good set of articles

The Wall Street Journal has a fine set of articles on the Fed and the recent problems in the financial markets.

Start with this one and then check out these two.

Posted by William Polley at 10:30 AM | Comments (0) | TrackBack

August 17, 2007

Fed cuts discount rate

Note: Earlier today my web host had a DNS meltdown. Since I was able to telnet to the site, I typed a makeshift "post" directly into the main blog page, knowing that I might not get a chance to log in until tonight. Now that the DNS issue has been fixed, I am putting the content of that "post" into a proper post. I have also added links to the Fed statements.

If you are reading this, then the DNS issue has resolved. However, I will need to be away from the computer for a few hours this afternoon, so I wanted to get a message up for when things are back to normal.

The irony is that even with all the shake up today, there isn't a whole lot to say that hasn't already been said. The Fed lowered the discount rate (something that I suggested a while back), but did not act to lower the fed funds target. They did, however, issue a statement which announced the new assessment of risk being more tilted towards lower growth than higher inflation. This does pave the way for a change in the target down the road if the need arises. I think it's fairly obvious that they want to hold off on that. If they didn't want to hold off, they would have just gone ahead and done it today. But I think that they correctly realize that we're moving into a period where the decisions are going to be made on a day-to-day basis. This statement, which is rare in announcing a shift in the bias between meetings without a change in the target, is simply an acknowledgment of that fact.

Remember, since the discount rate is a misnomer (it's really a premium rate now), the action today simply lowers the penalty that banks pay to borrow from the Fed directly. As Bagehot famously said, the appropriate thing to do here is to lend freely at a penalty rate. They're still doing that. It's just that in this circumstance a lower penalty is warranted so that if a larger liquidity squeeze develops banks might be encouraged to go to the discount window sooner. I wasn't sure they would do it--thinking that it could cause more panic. That didn't seem to happen, and I think the reason is that in the last few days more market participants have come to the realization that the Fed was going to do "something" and so it wasn't really all that unexpected, even though what they did was a bit unusual.

One final comment about the many commentators who have mentioned the lower effective fed funds rate. I covered this in my previous post, but here's one other thing to consider. I think in this case, it would be more useful to know what the median fed funds rate is. The effective rate is a weighted average and is being pulled down by trades at close to zero, which I think are due to the last trades of the day being excess reserves and have a lower reservation price. I don't think the median rate is computed, but if it was it would be more illuminating.

I still haven't come over to the camp that says that a rate cut in September is a sure thing. Everything I see is telling me that the Fed is doing whatever it can to avoid it. It may not be possible, but they will see how this cut in the discount rate plays out and take it from there.

There will be a rate cut if it looks as if the present situation is spilling over into overall gross domestic private investment (e.g. if commercial real estate, which has been stronger, begins to show signs of failing). That's when a cut in the target fed funds rate (which would lower the effective rate, as well as the high end of the range and the median) would be called for. The discount rate action today was not aimed at stimulating the economy, but rather to provide a marginally more attractive liquidity cushion.

I'm sure there will be lots of good commentary over the weekend and a highly anticipated opening of the markets on Monday.

UPDATE: James Hamilton offers the following excellent observations with which I completely agree.

I think that the Fed would prefer to rely on the automatic functioning of the discount window, rather than the multiple aggressive open market operations that we saw on August 10, to respond to the kind of challenges that have arisen in markets over the last few weeks. If the Fed really wants banks to go to the discount window rather than bid the fed funds rate up to 6% in response to these kinds of pressures, it makes sense to offer to lend through the discount window at the new lower rate of 5.75%, as well as extend the terms of these loans to 30 days, as the Fed did this Friday.

I believe that the Fed adjusted the discount rate rather than the target fed funds rate not because it's a back-door way to lower interest rates, but instead in order to address the specific policy objective of making sure the discount window gets used as part of the automatic response to the kinds of liquidity pressures that have been bobbing up these last two weeks.

Posted by William Polley at 6:09 PM | Comments (3) | TrackBack

August 15, 2007

Strange things in the fed funds market

Felix Salmon shows that the effective fed funds rate has dipped below 4.75%. Of course, given Friday's events, one would have expected the effective rate to have been low. Even Monday I can understand. But this seems to be lingering more than many would have expected. What's up?

First, let's do a graph showing not just the effective rate, which is a weighted average, but also the range. (Data)

And now we see the larger picture. The reason for that the effective rate has dropped a bit is because there are a few trades at very low (zero for Friday and Monday) interest rates. The high end of the range is right where you would expect it to be--consistent with the last month or so. But why the trades at or close to zero?

Remember, the Federal Reserve does not control this rate precisely. Also, even under normal conditions, the funds trade in a range. Creditworthiness of the borrower matters for a few basis points. So what the Fed does under normal circumstances is to try to get the weighted average... the preponderance of the trades, if you will... as close to the target as possible. It is quite normal to miss by a couple of basis points, but it's a testament to the institutional knowledge of the trading desk in New York that they can get it that close day in and day out.

Remember also that this infusion of liquidity represents reserves, or base money. It doesn't get multiplied through the deposit process unless banks lend those reserves to create new deposits. Something tells me that's not going to be an enormous risk in this case. Intermediaries are more likely to be carrying some excess reserves at this point. And they earn zero interest on those reserves. Hence, it's not entirely out of whack that at a time like this the market rate on those marginal excess reserves is significantly lower than the target. But zero?

Here's what Reuters had to say:

DOWN TO ZERO: According to data from The Federal Reserve Bank of New York, federal funds low trade of the session on both Friday and Monday was zero percent. On Friday, the highest traded intraday level was 6.05 percent, while Monday's intraday high was 5.5 percent.

Market analysts said the low trades showed that the Fed's liquidity infusions had been enough to bring down the cost of overnight money steeply as volume thinned in late afternoon trade. Data for federal funds on the New York Fed Web site goes back to January 2000 and shows that federal funds have not traded at zero before then, although they have come close.

In the aftermath of the Sept. 11, 2001 attacks, fed funds traded at 0.06 percent according to Federal Reserve data. In August 2004, fed funds traded at 0.03 percent.

A zero intraday trade for federal funds may be an even rarer event, analysts say.

"I find no evidence of federal funds trading at zero at any time since at least 1988," said Tony Crescenzi, chief bond market strategist, Miller, Tabak & Co. in New York.

So while I don't have a full and definitive explanation, it would seem that borrower risk is a factor, and the fact that these are excess reserves (which earn no interest) is also a factor. In that case, the low end of the range could stay low until the reserve picture gets back to normal. Soon we should get some data on excess reserves, which may shed some light on this situation.

In other words, I don't see this small fraction of trades at such a low level as being inflationary. Quite the contrary, if intermediaries want to hold more excess reserves as a risk management measure then the Fed is doing the right thing by offering those reserves. It only becomes a problem if those intermediaries run out and make more questionable loans with the money. I don't see that happening, and if it does, then (a) we'll call them on it, and (b) the Fed will likely pull back those reserves. Wouldn't you want intermediaries to respond to the recent turmoil by holding excess reserves? If so, then I wouldn't get worked up by some fed funds trading on the low side, even significantly on the low side.

I would suspect that it will creep slowly away from zero over the next few days (barring any other events), but the standard deviation is likely to remain higher than it was just a couple weeks ago.

Back the Reuters piece referenced above, this should also help:

SUPPLY: Issuance of Treasury bonds and notes can put upward pressure on federal funds, bond analysts say. For example, the settlement of last week's 10-year Treasury note and and 30-year Treasury bond auctions this week could put upward pressure on federal funds, said Josh Stiles, bond strategist and managing director with IDEAglobal in New York.

And of course, the Fed knows that and would have taken it into account when it made the 14 day repo last Thursday.

So don't get the impression that the funds rate has gone down in any meaningful sense until we see what the excess reserve picture looks like.

UPDATE: Tim Duy has some comments on this and on St. Louis Fed President William Poole's interview with Bloomberg. For the record, I agree with Tim that the temporary nature of most of the injection is the main reason that this is not inflationary. But I think the main reason we're seeing a few fed funds trades near zero interest is that those are the marginal trades of excess reserves. That intermediaries appear to be holding excess reserves even after much of last week's injection has been reversed is significant. This also puts some downward pressure on inflation if that practice continues.

UPDATE 2: The Fed injected another $12 billion in a 1 day repo and $5 billion in a 14 day repo this morning. The 14 day repo will correspond with the 14 day maintenance period for reserves which begins today. The Fed also announced that with the new maintenance period starting, they may need to inject more reserves but that should not be interpreted as a sign of a problem. For more, see this Wall Street Journal piece.

Posted by William Polley at 8:17 PM | Comments (0) | TrackBack

August 13, 2007

Excellent primer on what the Fed did and why they did it

Stephen Cecchetti: Subprime 'crisis' (voxeu.org)

Posted by William Polley at 5:32 PM | Comments (0) | TrackBack

Fed wins battle, war not over

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

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

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

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

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

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

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

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

Posted by William Polley at 10:23 AM | Comments (1) | TrackBack

August 10, 2007

Media appearance

I received an e-mail from King Banaian (SCSU Scholars) inviting me onto his radio program on AM1280 "The Patriot" WWTC in Minneapolis-St. Paul. The show is "The Final Word", part of the Northern Alliance Radio Network, and airs Saturday from 3-5pm Central. Tune in if you're in the Twin Cities. If not, the show streams here.

UPDATE: I was on for the 3:30 to 4:00 segment. Had a great time! Welcome to any listeners who found their way here.

Posted by William Polley at 10:58 PM | Comments (0) | TrackBack

Quite a day

The markets had a roller coaster day, but ended the week on the positive side. It's important to remember that the Fed's action today was not to save the market or prevent a crash or bail out the bankers. None of the above. This was much simpler. A lot of entities holding mortgage backed securities needed liquidity. They were willing to borrow at a higher overnight rate to get that liquidity as evidenced by the spike in the funds rate early in the morning. The Fed, quite understandably, did not want the funds rate to spike, and so they loaned these banks reserves accepting mortgage backed securities of the highest quality as collateral (the Fed was NOT bailing them out by buying distressed subprime loans). This kept anyone from unloading good quality assets at fire sale prices just to get liquidity. That would have been disastrous. The agreement is that on Monday the banks get their securities back and the Fed takes back the reserves.

Of course, on Monday they might have to do it again if there is still a need. And even after this immediate episode quiets down, there may be a need to do it later. As Felix Salmon points out (hat tip to King Banaian), the inability to roll over commercial paper can be the event that leads to problems of systemic risk. And that is very hard to predict whether and when it will happen again. All we can say is that it might happen.

Speculation has raged all day about whether the Fed will need to raise interest rates. Early on I was hearing on CNBC that the market was pricing in a 100% chance of a cut by, I believe, October. That seems to have died down a bit, at least on the binary options market. Now it's basically 50-50 by the September meeting (that includes the possibility of an intermeeting cut. October and December probabilities were 70 and 76 percent--little changed from yesterday. Obviously the Fed is trying to avoid lowering rates. They want to keep this a liquidity issue where the important thing is quantity not price. Price becomes more important if it is felt that this will contribute to the slowing of the economy in aggregate.

It was quite a day. But at the end of the day there was, I think, a feeling that in the aggregate we dodged one for now. High volatility is just something we'll have to get used to for a while.

UPDATE: MSNBC makes it seem worse than it was.

On Friday, as Bernanke faced the first big crisis of his 18-month tenure, the central bank was forced into action, buying up billions of dollars worth of crumbling bonds in an effort to stabilize financial markets that appeared to be coming unglued.

As Calculated Risk says, "Nope." They only accept high quality mortgage backed securities not "crumbling bonds."

Posted by William Polley at 6:51 PM | Comments (2) | TrackBack

Fed issues statement: "The Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets"

This just in from the Fed...

The Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets.

The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee's target rate of 5-1/4 percent. In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding.

Posted by William Polley at 8:19 AM | Comments (5) | TrackBack

Read this while you watch to see if more liquidity is needed this morning

Joellen Perry, Monica Houston-Waesch and Greg Ip have an excellent article in this morning's Wall St. Journal.

I had CNBC on in the kitchen as I was doing some other things so I didn't see who said this, but someone they interviewed reminded the viewers that this is a credit issue not an interest rate issue (or words to that effect). That is spot on. If liquidity is necessary to maintain the target, then so be it. But this is not a time for central bankers to overreact.

UPDATE: CNBC is reporting that the Fed put in $19 billion this morning.

UPDATE: Another $16 billion at 10:55 (EDT). Here is a link to the NY Fed page for temporary open market operations.

UPDATE: Another $3 billion at 1:50 (EDT).

Posted by William Polley at 7:07 AM | Comments (0) | TrackBack

August 9, 2007

Fed pumps liquidity into market

It started in Europe when French bank BNP froze $2.2 billion in funds. (Reuters)

"The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly, regardless of their quality or credit rating," it said in a statement.

The European Central Bank immediately injected almost 95 billion euros into the market. This morning, the concerns had spread to the U.S. Fed funds were trading at between 5.375 and 5.5% early in the day according to this Wall Street Journal article. In order to keep the funds rate at its target, the Fed injected $24 billion in a two week repo and $12 billion in an overnight repo. The Journal article states:

The average rate at which the money was lent was also marginally higher than normal, an indication of the strength of demand for cash. "What has happened so far is interesting but not extraordinary," said Ray Stone of Stone & McCarthy Associates, an economics and markets research firm. The Fed, he said, is probably having trouble estimating demand for excess reserves because of the "strain in the credit market" which is adding to the pressure on reserves.

That's probably understating it a bit. What spilled over across the Atlantic was not anticipated today. At best, you might expect that something like this could have happened sometime. It happens that today was the day, and thus was a bit of a surprise.

Are we out of the woods? Not really. Again, from the WSJ:

One risk the Fed faces is that if it injects too much cash, the Fed funds rate would plummet later on to below its target. However, unlike in previous eras, that is unlikely to be interpreted as a deliberate easing of monetary policy. Since 1994, the Fed has announced when it is changing its target for fed funds. After the Sept. 11, 2001, terrorist attacks disrupted markets and sent demand for cash soaring in 2001, the Fed poured money into the system and warned this could send the fed funds rate below its target.

Correct. The same is true here, but on (for now at least) a much smaller scale. This is not an emergency, and indeed the Fed's injection is much smaller than the ECB's injection. Furthermore, the Fed's injection was not aimed at calming a panic, but rather at maintaining the target.

The Fed did the right thing in maintaining the target. If there are no other incidents of banks freezing funds, then this may be enough. But the real question is now, what next?

That's a tough question to answer. It is certainly possible that another bank or hedge fund will find itself in trouble before the mortgage mess straightens itself out. In fact, it's probably pretty likely. It's just that no one knows who, when, or how big. So what is the Fed's role? I keep going back to one of my favorite papers by my fellow Iowa alum Chris Neely. Neely chronicles the use of various methods of providing liquidity: repos, discount window lending, and float, in response to various crises.

Let us not forget the discount window, which really is a misnomer these days. The term refers to the fact that it used to be typically a bit lower than the funds rate. A few years ago, the discount window policy changed. Today, there are actually two discount rates, primary and secondary credit rates. Primary credit is available at a rate of 6.25% and secondary credit at 6.75%. You can read about the specifics here.

Today's intervention was just a ripple in an ocean, but in the event that something more is on the horizon, the Fed needs to remind banks that the discount window is always there to meet their emergency liquidity needs. If anything, the Fed might consider lowering the discount rate to marginally encourage borrowing from that source rather than putting strain on the fed funds market. Lowering the fed funds rate should not be the first reaction to this situation despite the fact that many people will call for it. Lower the fed funds target only if it looks like this is not going to be contained by the financial markets.

This is not (yet) a crisis on the scale of others we have seen. Whether more injections from the Fed will be required to prevent counterparty risk and systemic risk remains to be seen, though I am confident that they will supply the liquidity if required. As for the funds rate, the carnage at the CBOT suggests that either others are not as confident that this will be contained, or they believe that the Fed is on the verge of giving in. The first is a possibility that cannot be ruled out. The second is, I hope, a misguided notion.

Still, it was quite a significant event that took place today.

UPDATE: Mark Thoma must have sneaked a peak at the lecture I plan on giving my intermediate macro class on day one this fall. Very nice exposition.

UPDATE 2: Felix Salmon notes this Wall Street Journal piece that says the subprime mess may have extended its reach into the money market. That would certainly raise the risk that this will cause problems in the wider world. That is not something that you like to see.

Posted by William Polley at 2:47 PM | Comments (0) | TrackBack

August 8, 2007

Fed funds options continue to return to something approaching normalcy

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

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

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

I call the last couple weeks, "Denial."

Posted by William Polley at 3:29 PM | Comments (0) | TrackBack

August 7, 2007

Fed funds options reflect changed outlook

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

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

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

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

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

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

UPDATE: The NY Times editors are in denial.

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

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

They would have done well to listen to Cassandra.

Posted by William Polley at 10:24 PM | Comments (4) | TrackBack

FOMC statement

FOMC statement for August 7, 2007:

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

Economic growth was moderate during the first half of the year. Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.

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

Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on 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; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Michael H. Moskow; William Poole; Eric Rosengren; and Kevin M. Warsh.

The paragraph on inflation is unchanged. In the live coverage on CNBC after the announcement, this part had Jim Cramer a little riled up. Perhaps someone will have that on YouTube. (Aside: Someone made a comment to Cramer during the coverage about his YouTube fame. Priceless.) In keeping with the Chairman's statements a couple weeks ago, I'm really not surprised about this. After all, last months inflation figures just barely took 12 month core inflation into the comfort zone. It is understandable that they would not declare victory yet.

The real meat of the statement is in the additional wording in the other paragraphs. They say, "Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses,..." As many suggested they should, the Fed acknowledged the fact that there is a bit of a liquidity squeeze. This is significant. I don't recall anything quite this forthcoming in past statement. The closest thing in recent memory are the minutes to the August 18, 1998 meeting which included statements about increased volatility and widening risk spreads.

Finally, they say:

Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.

You'd still have to call it an asymmetric bias, but it does reflect a little bit of a changing sentiment. The downside risks should not increase appreciably further unless the unwinding of the mortgage market affects credit conditions more broadly. After all, they mentioned the "solid growth in employment and incomes and a robust global economy" in the first part of the statement. But the bottom line remains that the Fed is going to not jump to rescue the mortgage banks unless they would risk a systemic failure of the system through their inaction. It is not the Fed's job to be an enabler.

UPDATE: For a while the Dow was down, now it's up close to 100 points. As usual, the Wall Street Journal's coverage is excellent with an article, a comment on the Real Time Economics blog about how past statements have reflected new risks, and of course the "Economists React" page, which is as colorful as ever and mostly on target.

The Real Time blog references the 1998 situation as I did above. However, they were looking at the statements, which had a much different character then. I looked at the minutes which provide more detail, and at that time, the August minutes and the September statement would have come out roughly simultaneously. The minutes to todays meeting should prove just as interesting.

Posted by William Polley at 1:57 PM | Comments (2) | TrackBack

All eyes on the Fed

Later today, the FOMC meets to do what they do every six weeks or so...determine the target federal funds rate going forward. What will they do? What will the press release say? And what does it all mean? Those are going to be the questions on people's minds. Here's what a NY Times article, which quotes Jared Bernstein of the Economic Policy Institute says:

By taking a firm line in the current credit crunch, Mr. Bernanke can show investors that they cannot count on the Fed to save them from market swings, Mr. Bernstein said.

“This would be a good time for the Fed to impose some discipline on financial markets that we haven’t seen in a while,” he said.

But, in an illustration of the fine line that Mr. Bernanke must walk, Mr. Bernstein said he hopes the Fed considers lowering interest rates this fall, not to help Wall Street and hedge funds, but to lower the risk of an economic slowdown that would hurt middle-income Americans. With core inflation, excluding food and energy, running under 2 percent annually, the Fed has room to lower rates, Mr. Bernstein said.

By contrast, Jim Cramer wants Bernanke to save Wall Street. Check out the videos on Ritholtz's page too.

Fed funds options across the board are showing that the market is increasingly expecting the Fed to ease before the end of the year. The binary call option for December closed at 50 points today. Why it seems like just a few days ago it opened at 41. How I wish I had the sort of deep pockets to play in that market. Judging by the spread in the contract prices it looks like September...the next meeting after today... is where the market is increasingly putting its money. There was even some activity on the August contract as some traders are apparently hedging their position...just in case.

But any movement tomorrow is still a very long shot. The key will be the statement. Will they keep this language?

The economy seems likely to continue to expand at a moderate pace over coming quarters.

As the discussion of the latest GDP numbers showed, a lot of people believe that the economy will expand at a slower pace. The problem for the Fed is that if they change the language, it will cause a surge in the market as everyone re-evaluates their positions in light of the higher probability that the Fed will ease in September. It becomes a dangerous game of chicken if the Fed changes its language but doesn't follow through at the next meeting. How good is Mr. Bernanke's poker face? A shift in language now might as well be a rate cut now because it will be priced in by close of business.

Or, the Fed could retain the existing language. At the very least, this would be likely to provoke another tirade from Cramer. But seriously, this would lead to the market trying to guess whether Bernanke is playing chicken with them. We might see some disconnect in the bond market like we saw earlier this year. Ultimately, any rate cut, if and when it comes, will be more of a surprise, perhaps even an unscheduled one like in 2001. I wouldn't discount that as a mechanism that the Fed could use if they wanted to avoid the scenario of the previous paragraph.

Then there is this sentence from the last press release:

However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated.

But the latest inflation numbers were encouraging. At the moment, core inflation over the last 12 months has been under 2%, barely in the "comfort zone". Perhaps a modification of this sentence is in order, moderating the language just a bit. Truly, this is where a real target or a policy rule would be handy.

Finally, the sentence everyone will be looking at is this:

In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.

This would have reflected the Chairman's outlook as recently as a couple of weeks ago when he visited Capitol Hill. Last week's numbers aside, there is likely to be a significant contingent in the FOMC who continue to see inflation as the larger risk. For them, even if growth slows to 1 or 2% in the remainder of this year, the potential to rekindle the inflation expectations is too great to risk on a rate cut now, or even the suggestion of one next month. Stay the course and continue to hope that the subprime mess doesn't totally unwind.

And it is that subprime mess that presents the critical test for the Fed. It is not their job to take away the risk of failure of these loans. However, their job is to ensure that it does not cascade into a problem of systemic risk. Willem Buiter has a point. Remind the firms that the discount window is open if they need liquidity to meet their obligations, perhaps even at a penalty rate (though that's pretty unlikely to be adopted in practice by this Fed). Be the lender of last resort, not the enabler of first resort. Wall Street won't like it, but it will be better than the alternatives.

As a student of the Great Depression, Mr. Bernanke certainly understands these issues well... better than most commentators gave him credit for a couple years ago. And for that reason, I think it is safe to say that the Fed will keep rates the same tomorrow and any change in language is going to be very subtle.

Predictably the market will overreact. Bonds might do some weird things for a while. That would not be new. And the Fed will continue to hope that it can pull it off again next month. In the meantime, we'll keep watching and waiting.

Posted by William Polley at 12:15 AM | Comments (1) | TrackBack

August 2, 2007

Willem Buiter has a blog

Via Marginal Revolution we read that Willem Buiter is blogging. It's off to a good start. Here's a slice of a recent post titled "If there’s a credit crunch, leave the Fed Funds rate alone, raise the discount rate and use the discount window".

The central bank (the Fed, as the central bank faced most directly with the mess of the sub-prime mortgage debacle – a mess to a large extent of the Fed’s making) therefore most respond to a credit crunch by guaranteeing the liquidity of a wide range of instruments held by private parties, instruments that without the Fed’s intervention would become illiquid. The Fed should do so by following Bagehot’s 150-year old advice. With one slight clarifying amendment, that advice is as follows: in times of financial stress and distress, lend freely, at a penalty rate, against collateral that would be good in normal times but may by heavily impaired in the extraordinary times prompting the Fed’s intervention.

As they say, read the whole thing.

Posted by William Polley at 11:13 PM | Comments (0) | TrackBack

July 30, 2007

Charles Evans to lead Chicago Fed

Michael Moskow is stepping down from his post as president of the Chicago Fed at the end of August. Next week will be his last FOMC meeting. He's been at the helm at the Chicago Fed for almost as long as I've been following the Fed's activities. We wish him well in his retirement.

Today it was announced that Charles Evans, currently the Chicago Fed's director of research will succeed Mr. Moskow. Quoting from the press release:

CHICAGO- (July 30, 2007) - The Federal Reserve Bank of Chicago today announced that Charles L. Evans will become the bank's ninth president and CEO effective September 1, 2007.

Evans, 49, will replace Michael H. Moskow, who will retire August 31 after 13 years as president. The announcement was made by Miles D. White, CEO of Abbott Laboratories and chairman of the bank's board of directors. White chaired the board's search committee responsible for the selection of the new president.

Evans is currently senior vice president and director of research at the Federal Reserve Bank of Chicago. He also oversees the bank's Office of Consumer and Community Affairs and its Office of Public Affairs. He joined the Chicago Fed in 1991 and has been director of research since 2003. In that capacity he coordinates all monetary policy support for the president and the board of directors, with responsibility for research into the conduct of monetary policy and the structure of the macroeconomy.

Evans is well respected for his research on inflation, financial market prices and measuring the effects of monetary policy on U.S. economic activity. His research has been published in the Journal of Political Economy, American Economic Review, Journal of Monetary Economics, Quarterly Journal of Economics, and the Handbook of Macroeconomics.

"After a comprehensive search in which we interviewed several excellent candidates, we decided that Charlie is best qualified to lead the Federal Reserve Bank of Chicago," White said. "He has excellent leadership skills, knows the Federal Reserve System well, and has participated at the highest level of the monetary policy-making process."

Charles Evans CV

Wall Street Journal article

I live in the Chicago Fed district and am involved with their Fed Challenge (judge for the HS competition and WIU's coach for the college competition), so I take a special interest in this one. I think Evans is a great choice for the position and look forward to more quality work coming from Chicago.

Posted by William Polley at 11:00 PM | Comments (0) | TrackBack

July 27, 2007

Trading in binary Fed options

After reading the latest GDP news, I went poking around the CBOT website to see how things were going on the futures market for fed funds. One thing caught my eye. Shortly before noon today, there was a posting of a trade of 500 Fed Binary Options for December 07. Specifically, they were call options with a strike price of 94750. The trade was completed at a price of 41 ($410 per contract). That is the only open interest on that contract so far.

Here's what this means. A long position in this contract receives $1000 per contract if the fed funds target is less than 5.25% (the prevailing rate today) on the day after the December 2007 FOMC meeting. Essentially, two parties were able to agree on a bet that effectively indicates a subjective probability of a rate cut by December at 41%.

In case you're interested, the latest prices for similar options maturing in August, September, and October are 9, 20, and 28 respectively.

The more traditional 30 day futures on fed funds were broadly higher as well, though yesterday's moves in light of the continued housing difficulties were larger. Today's GDP numbers seemed to reinforce yesterday's news. September contracts on the IEM have not started to move much yet. We'll keep in eye on that.

It will indeed be interesting to watch the binary options on the CBOT in the coming weeks. Keep it tuned right here for the coverage.

Posted by William Polley at 3:54 PM | Comments (2) | TrackBack

July 19, 2007

Fed links

I don't have a lot of time to comment on these today, but here are the links to Chairman Bernanke's testimony, the full report to Congress from the Board, and the most recent minutes of the FOMC.

Posted by William Polley at 3:56 PM | Comments (0) | TrackBack

July 17, 2007

David Altig named Research Director at the Atlanta Fed

Congratulations, David! Via the Real Time Economics blog at the Wall Street Journal. (Hat tip: Mark Thoma)

Economics blogging can be good for your career. David Altig, author of the Macroblog has just been named research director of the Federal Reserve Bank of Atlanta.

Mr. Altig is currently associate research director at the Federal Reserve Bank of Cleveland and also teaches at the University of Chicago Graduate School of Business. His blog postings reflect a mainstream Fed view on key macroeconomic questions of the day.

In an interview, Mr. Altig said he doesn’t know if the blog will continue in his new job. “I‘ve been at it for a while, and I enjoy it but I have to take the lay of the land there and see whether my responsibilities are consistent with keeping it up or not.” A start date hasn’t been announced.

David's blog is one of the best when it comes to macro and monetary policy. At the moment, I have more of his posts saved in my feedreader than from any other blog. That says something. His blog started up about the same time as mine, and he was one of the first in the economics wing of the blogsphere to notice this little blog.

His analysis often includes a statement of the conventional wisdom with a healthy dose of reality. His post yesterday is another good one in that tradition.

I wish David the very best in his new position, and I hope that his blog will continue, even if it is in a less frequent form.

Posted by William Polley at 4:28 PM | Comments (0) | TrackBack

July 16, 2007

On the calendar this week

Federal Reserve Chair Ben Bernanke testifies before both houses of Congress this week. He goes to the House Financial Services Committee on Wednesday at 10am EDT. Their web site says that they will webcast the hearing. On Thursday at 9:30am EDT, he goes to the Senate Banking Committee. No webcast information is available at this time (at least that I can find).

Posted by William Polley at 2:51 AM | Comments (0) | TrackBack

July 11, 2007

Reserve growth in the BRICs

In this excellent post, Brad Setser looks at the growth of reserves of foreign central banks, particularly in Brazil, Russia, India, and China (often referred to as the BRICs), and says that they are "simply too big not to matter".

Posted by William Polley at 1:44 AM | Comments (0) | TrackBack

June 28, 2007

Quo vadis?

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

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

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

And here is what they said in May:

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

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

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

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

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

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

...

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

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

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

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

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

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

Posted by William Polley at 2:24 PM | Comments (0) | TrackBack

June 27, 2007

The Wall St. Journal is openly hawkish

Read the whole thing.

All indications are that the Fed will keep its 5.25% target fed funds rate today, while perhaps fiddling with its accompanying policy "guidance." We'd feel better, however, if the Governors leaned toward protecting the dollar and curbing any credit excesses built on expectations of future dollar inflation around the world.

They listened to Cassandra.

Posted by William Polley at 11:24 PM | Comments (0) | TrackBack

June 13, 2007

Three items relating to the Fed

So I was checking my Reuters news feed and these three caught my eye.

Fed mulling ban on some mortgage lending: Kroszner

"We will also seriously consider whether there are mortgage lending practices that should be prohibited," Kroszner said in prepared remarks at a U.S. House of Representatives Financial Services Committee discussion on consumer protection.

Kroszner said the Fed was specifically eyeing 'stated-income' loan applications and prepayment penalties, as well as considering whether lenders should require monthly payments of annual fees like taxes.

...

"We must be careful, however, not to curtail responsible subprime lending or beneficial financing options for consumers," Kroszner said.

Meanwhile, south of the border, the former Fed chair gets the newswires buzzing...

Greenspan: Disinflationary process may be reversing

MEXICO CITY (Reuters) - Former Federal Reserve Chairman Alan Greenspan on Wednesday said a rise in the cost of Chinese goods imported into the United States may be a signal a long disinflationary trend may be reversing.

"That is the first sign that I have seen that disinflationary pressure ... may be turning around finally," the former U.S. central bank chief said, referring to U.S. data released earlier on Wednesday.

His comments came after the U.S. Labor Department on Wednesday released data showing that U.S. import prices for goods from China rose 0.3 percent in May, the largest monthly gain since this measure was first published in January 2004.

Speaking to a business exposition via videoconference, Greenspan said it was inevitable that at some point the downward pressure on inflation stemming from the opening of emerging economies would come to an end.

Back in Washington, the Beige Book was released.

Fed's Beige Book: Economy expanded through May

WASHINGTON (Reuters) - Economic activity expanded from mid-April through May, with a number of areas reporting stronger growth, the Federal Reserve said on Wednesday.

Seven Fed districts described growth as modest or moderate, while others reported growth as moderately strong, edging up, or somewhat faster than in recent months, according to the Fed's Beige Book summary of anecdotal economic conditions.

The Fed said overall wage pressures had not increased, but added that there were "significant" price increases for energy-related products.

However, districts generally did not indicate an increase in overall price pressures, the U.S. central bank said.

You can read the entire Beige Book at the Fed's website. With the exception of residential real estate, it's a fairly good report. Only Richmond reported a decline in manufacturing, and more than half the districts reported increased commercial real estate leasing activity. Price pressures are still clouded by higher energy prices nationwide and higher materials prices in some areas. Nothing in the report changes my assessment of where the Fed is heading for the rest of this year.

Posted by William Polley at 2:41 PM | Comments (0) | TrackBack

June 4, 2007

Hard to see a rate cut anytime soon

Reuters headline: Wall St. backs off calls for Fed rate cuts

NEW YORK (Reuters) - Renewed signs of strength in the U.S. economy have forced a number of Wall Street firms to back away from forecasts for interest rate cuts this year.

Merrill Lynch's shift was the most drastic. It went from predicting the Federal Reserve would lower rates by a full percentage point to not seeing any reductions at all.

"The Fed is not going to be cutting rates at any time this year," said David Rosenberg, chief economist for North America at Merrill Lynch.

Back on December 7, I wrote:

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.

A couple months later, I looked back on that call:

Thank goodness for my inner Cassandra for keeping me from jumping all the way on that bandwagon.

In recent weeks it seemed that the pendulum was swinging back in favor of looking for a rate cut, but I'm still not on that bandwagon. Not yet anyway. Listen to Cassandra.

Of course the lackluster first quarter GDP is one factor keeping me from going all out and predicting an increase in the fed funds rate right now. However, there are reasons for guarded optimism. There are also good reasons to be cautious.

When it is time for them to move, in either direction, it will probably come without much warning.

Posted by William Polley at 4:05 PM | Comments (0) | TrackBack

May 30, 2007

FOMC Minutes

Minutes from the May FOMC meeting were released today. Here are a couple of key paragraphs.

Market participants had largely anticipated the FOMC's decision at its March meeting to leave the target federal funds rate unchanged. Nevertheless, the expected path for monetary policy moved lower on the announcement, as investors apparently interpreted the accompanying statement as suggesting that the Committee's economic outlook had become somewhat more balanced. However, subsequent FOMC communications--including the Chairman's testimony before the Joint Economic Committee, speeches by various FOMC members, and the minutes from the March meeting--were generally seen as emphasizing the Committee's concern about upside risks to inflation....

...

... Meeting participants anticipated that real GDP would advance at a pace a little below the economy's trend rate of growth through the remainder of this year and then pick up to a rate broadly in line with the economy's trend rate in 2008. Most participants continued to expect core inflation to slow gradually, although considerable uncertainty surrounded that judgment and the Committee's predominant concern remained the risk that inflation would fail to moderate as expected.

...

...most participants agreed that, although the level of inventories of unsold homes that homebuilders desired was uncertain, the correction of the housing sector was likely to continue to weigh heavily on economic activity through most of this year--somewhat longer than previously expected.

...

Nearly all participants viewed core inflation as remaining uncomfortably high and stressed the importance of further moderation. Although readings on core inflation in March had been more favorable, this followed several months of elevated inflation data and price pressures were not yet viewed as convincingly on a downward trend. Most participants expected core inflation to moderate gradually, fostered in part by stable inflation expectations and a likely deceleration in shelter costs. Some participants also expected the anticipated slight easing of pressures on resources to help nudge inflation lower, although others felt that small movements in resource utilization were unlikely to have discernible effects on inflation. All participants agreed that the risks around the anticipated moderation in inflation were to the upside; and some noted that a failure of inflation to moderate could entail significant costs particularly if it led to an upward drift in inflation expectations.

... Members continued to view the risks to economic activity as weighted to the downside, although with turmoil in the subprime market appearing to have remained relatively well contained and business spending indicators suggesting a more encouraging outlook, these downside risks were judged to have diminished slightly. Members agreed that considerable uncertainty attended the prospects for inflation, and the risk that inflation would fail to moderate as desired remained the Committee's predominant concern.

... While readings on core inflation were lower in March, members felt that it was appropriate to emphasize that core inflation remained somewhat elevated. The Committee agreed that the statement should continue to note that their predominant policy concern was the risk that inflation would fail to moderate as expected, and that future policy adjustments would depend on the evolution of the outlook for both inflation and economic growth.

Look at the number of times that upside risks to inflation is cited as the "predominant policy concern." There is also an acknowledgment that the correction in the housing market is likely to go on "somewhat longer than previously expected."

Also, next month, the FOMC will continue its review of communication issues. It will be interesting to see what comes of that as it is a topic that I have mentioned many times on this blog, and I know that many of my readers are interested. All in all, my expectations for interest rate policy have not changed much in the near term from what I have mentioned in the past. I see the Fed trying to talk down inflation expectations as much as they can while they wait for a clear signal to move. Absent a clear shift in the data, I expect that to continue for a while. But if (when?) that shift comes, there will probably not be a lot of warning.

Posted by William Polley at 2:38 PM | Comments (0) | TrackBack

May 10, 2007

Best FOMC link summary

Macroblog today is a must read. My intermediate macro class I wrote about a few days ago would fit very nicely across that spectrum.

Anyway, go read Altig's post, and enjoy.

Posted by William Polley at 1:42 PM | Comments (0) | TrackBack

At least it's not a measured pace

Felix Salmon links to my analysis of the FOMC statement (as well as Mark Thoma's and Barry Ritholtz's). He writes:

For instance, the markets spent much of yesterday wondering exactly what the difference is between these two sentences:

Recent readings on core inflation have been somewhat elevated.

Core inflation remains somewhat elevated.

This is a waste not only of the FOMC's time, but also of the time of hundreds of analysts who suddenly find themselves in the position of rune-readers.

While I am sympathetic to Salmon's general point, this particular sentence did not exactly cause me to agonize for hours--more like seconds. Two months out of the last five have seen pretty decent readings on the core PCE deflator and the trend seems to be in the right direction. Nevertheless year-on-year inflation is still higher than they'd like it to be. Especially given the March number, the first sentence doesn't really ring true. The second one fits the bill a little better. Personally, I would not read anything more into it than that. Your mileage may vary.

I don't think much of Salmon's suggestion to have a different committee member write the statement and sign it each time. That would be even harder for the market to deal with. Salmon then concludes:

In any case, I think the best solution would be something which would concentrate the markets on the substance of what is being said, rather than on the silly differences between what is said this time and what was said last time. Surely that must be possible somehow.

Well, there's inflation targeting, I suppose.

Posted by William Polley at 1:11 PM | Comments (0) | TrackBack

May 9, 2007

FOMC statement...status quo... for now

Today's statement is slightly more terse with only very minor changes from the last one. Want to parse the words? Be my guest. Here's the statement with old language struck through and new language in bold.

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

Economic growth slowed in the first part of this year Recent indicators have been mixed and the adjustment in the housing sector is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters.

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

In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments 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; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Cathy E. Minehan; Frederic S. Mishkin; Michael H. Moskow; William Poole; and Kevin M. Warsh.

The statement on the web has a typo in which "Voting for the FOMC monetary policy action were:" is repeated--a classic cut-and-paste typo. Ooops. [UPDATE: This has been fixed.]

Anyway, the only changes in this statement are of the sort that acknowledge recent data. The first change is a direct reference to the slow growth in the 1st quarter. That acknowledgment requires deleting the words "continue to" in the next sentence. Since growth has slowed, it cannot continue at a moderate pace.

In the next paragraph, they take out the mention of "recent readings" on core inflation to reflect the fact that we have seen a couple of encouraging data points, but even so it is not enough to knock the hawk off of its perch. Most notable though is the fact that they retained the language that singles out inflation as the predominant policy concern. Of course it will not surprise you to hear me say that I'm not surprised. Why?

Here's the bottom line. A shift in the stance of the press release would be interpreted as tantamount to an admission that a rate cut is coming at the next meeting. I say this based on how I have seen the markets react in recent months. A shift in the language would cause such a realignment of the financial markets (some of it justified, some of it bound to be overreaction) that they won't do it until they absolutely have to. It's not optimal, but I don't see how it can be avoided now. Look at 2000-2001. Before the unscheduled policy action in January 2001, there was one warning in December. The November statement warned of inflation risks. Read it for yourself if your memory is fuzzy.

Inflation is still the main concern, but it is more of a known quantity. The problem is less a fear that inflation will spike (though that is not ruled out) but that it will remain above where a lot of people want it to be. The spending (i.e. demand) side of the equation is more of an unknown. As long as that remains the case don't expect anything to change. At the very least, we'll probably have to wait through a couple of revisions of 1st quarter GDP and a couple more inflation data points. Stay tuned. If something changes for the worse, there will probably not be a lot of warning. On the flip side, if you're waiting for an "all clear" you have a long, nerve-wracking wait ahead of you.

Posted by William Polley at 1:35 PM | Comments (0) | TrackBack

May 4, 2007

Other shoe poised to drop?

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

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

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

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

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

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

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

...

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

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

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

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

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

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

Posted by William Polley at 2:07 PM | Comments (0) | TrackBack

May 1, 2007

What will the Fed do? (According to my class)

Each semsester, my intermediate macro class does an FOMC simulation. Today was the day. The have been researching current economic conditions, the speeches by Fed officials, and so forth. At the end, I polled the class on what action the Fed should take. Of my students, 13 voted to hold interest rates steady. 2 voted to raise, and 2 voted to lower the funds rate.

This is, of course, a completely unscientific poll, but they learned a lot from it. It is the first time in all the semesters that I have assigned this project that there were people favoring three different possibilities.

Posted by William Polley at 11:11 PM | Comments (3) | TrackBack

April 25, 2007

Beige Book

The Beige Book was released today. Some media reports quote only the first half of the first sentence. The second half is also noteworthy.

Most Federal Reserve Districts noted only modest or moderate expansions in economic activity since the previous report, however two--New York and Minneapolis--reported steady and firm growth, respectively, and Dallas characterized growth as moderately strong.

Two of the three districts reporting the strongest overall economic activity cited manufacturing.

Manufacturing activity remained slow overall, although reports on conditions in the manufacturing sector varied across Districts. Dallas and Minneapolis, for example, reported expansion, while Chicago reported a recent firming of activity.

On labor markets,

Most Districts reported continuing tight labor market conditions, especially for skilled occupations, although several Districts reported expansions in employment levels.

How does that translate to wages? It depends on the sector.

Wage increases were reported in some industries of the New York, Philadelphia, Richmond, Atlanta, Chicago, Minneapolis, Kansas City, Dallas, and San Francisco Districts. These were generally modest. Specifically, the New York, Richmond, Atlanta, and Dallas Districts noted wage increases in some services sectors, and the Richmond District also noted faster wage growth in the retail sector. The Dallas District noted that continued layoffs reported by homebuilders and some manufacturers resulted in downward wage pressures. The San Francisco District indicated that wage pressures eased in the construction and agriculture sectors. Except for energy-related businesses, wage pressures in the Cleveland District were largely contained, but wage pressures edged higher in the Kansas City District. There were reports of wage pressures for skilled workers in the Dallas District and for in-store pharmacists in the Cleveland District. The Chicago, Dallas, and San Francisco Districts also noted faster growth in pay rates for some skilled positions.

What about inflation pressures?

Consumer prices remained generally stable or increased modestly, but most Districts reported a rise in input prices, particularly for metals and raw materials. However, a number of Districts reported low or declining lumber prices. Higher energy and/or fuel costs were noted in the Philadelphia, Richmond, Atlanta, Chicago, Minneapolis, Kansas City, and Dallas Districts. In response to higher input prices, some manufacturing businesses in the Boston, Cleveland, Chicago, and Dallas Districts were able to raise output prices. In contrast, some manufacturers in the Kansas City and San Francisco District were unable to raise output prices. Retailers and service firms in the New York, Philadelphia, Kansas City, Richmond, and Dallas Districts indicated that prices remained stable or increased modestly.

Posted by William Polley at 10:21 PM | Comments (0) | TrackBack

April 20, 2007

Illinois Fed Challenge

Yesterday, I was at the Chicago Fed helping to judge the high school Fed Challenge. I was impressed with the overall quality of presentations. Hopefully some of them will go on to compete in the college version of the competition.

The overwhelming (unanimous?) consensus of the teams competing was to keep the target for the fed funds rate unchanged. No surprises there.

In the Illinois competition, it appears that the schools were all from the Chicago area. Here's hoping that some downstate schools will get involved. It would be great to see the program grow. The more students are exposed to economics in the high schools, the better.

As a side note, Tim Schilling (who works tirelessly at organizing these competitions all around the 7th District) tells me that for my judging efforts I will receive an official "Fed Challenge T-shirt". When it arrives, you can expect a photo for the blog.

As another side note, after the competition, I had a couple hours in Chicago before catching the train home. I spent that time (and could have spent hours more) at the Art Institute of Chicago. The featured exhibition right now is Cezanne to Picasso: Ambroise Vollard, Patron of the Avant-Garde. Well worth your time and the price of admission.

Posted by William Polley at 3:56 PM | Comments (2) | TrackBack

April 16, 2007

Resuming transmissions

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

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

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

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

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

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

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

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

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

Posted by William Polley at 11:30 PM | Comments (2) | TrackBack

March 21, 2007

FOMC statement

Here is the link (FOMC Statement). The text of the statement is as follows:

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

Recent indicators have been mixed and the adjustment in the housing sector is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters.

Recent readings on core inflation have been somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.

In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

A lot of folks would probably say that the part about "the adjustment to the housing sector is ongoing" is a bit of an understatement. Be that as it may, the major (and it is major) difference between this statement and previous ones is the last paragraph. Repeating for emphasis:

In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.

Also notable is that the very next sentence leaves out a word that was in the last statement: "firming"

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

(Old language struck-through)

Of course, long time readers know that inflation has been my concern for most of the latter part of the Fed's tightening cycle and the first few months after they stopped raising rates. At the same time, the other wing of the blogosphere has been more concerned about the potential for slowdown and the possibility that rates will be cut.

So is it more hawkish that they called attention to the fact that their predominant concern is that inflation will fail to moderate. Does calling attention to this concern imply that they stand ready to raise rates if inflation stays stuck at its current level (or worse, trends back up)?

Or does the removal of the word "firming" mean that rates hikes are on the back burner? Is this to say that yes, they are concerned about inflation, but they don't anticipate acting on that concern any time soon?

The markets have spoken. (Reuters)

NEW YORK (Reuters) - Stocks rallied on Wednesday, driving each of the major indexes up 1 percent or more, after the Federal Reserve left interest rates unchanged and said the economy seemed likely to continue expanding at a moderate pace.

...

The Fed said it remained concerned about inflation but left out a reference to further "firming" of monetary policy that was contained in its previous statement. The Fed noted difficulties in the housing sector but said the economy is likely to keep expanding nevertheless.

"The markets obviously are disappointed that there is no sign of a Fed easing in the immediate future," said Scott Fullman, director of investment strategy at I.A. Englander & Co., an institutional broker-dealer in New York. "However, the fact that the economy continues to grow and that the Fed is not concerned about contraction should be favorable for stocks."

Based on this it would seem that the market was all excited about the removal of the word "firming." But I think they may be underestimating the statement about inflation being the predominant policy concern. What you are seeing here is a Fed that desperately wants to avoid painting itself into a corner. (Measured pace, anyone?) This statement reflects a slightly more flexible position than the previous one which really wasn't much changed from when they stopped raising rates in the summer. They are recognizing, correctly in my opinion, that the timing and now even the direction of any future change is more of a toss up than it was last fall. In a sense, it is a little bit of a surprise to me that there was not a further rate hike after the pause. Some (e.g. Richmond's Mr. Lacker) would have wanted one at the time. The statement was tilted in that direction.

While that is still possible, the date of any further firming (or loosening) always seems to be a bit over the horizon. Anyone want to put money on a rate hike or rate cut at the next meeting? No, the odds are that in May it will still be status quo. Recognizing this, the Fed is quite sensibly giving itself a little wiggle room. The way I see it, this statement makes it marginally easier (i.e. less of a hit to their credibility) to cut rates if they are forced to without really affecting their ability to raise rates should that become necessary. If that is the thinking behind the change, it seems the sensible thing to do. I think this does set up the possibility for a move on rates in the 2nd half of 2007. The direction remains to be seen.

UPDATE: Mark Thoma comments with the detailed sentence-by-sentence breakdown of the changes. The NY Times' Edmund Andrews gets a good quote.

“We can’t fathom how anyone could interpret the comments as a fundamental change in Fed thinking toward a neutral stance,” wrote Bernard Baumohl, managing director of the Economic Outlook Group, a forecasting firm in Princeton Junction, N.J.

A more likely interpretation is that Ben S. Bernanke, the Fed chairman, recognized signs of trouble in the housing market and wanted to give the Fed more room to maneuver.

Bingo. They bought themselves some wiggle room without sacrificing too much credibility. This is not a setup for a summer rate cut but a recognition that the direction of the next change, whenever that may be, is less certain than it was 6 months ago. A lot has changed. The only thing that I think it is safe to say is that (barring disaster) the next move of any kind is far enough in the future that we can't even see clearly which way it will go. At times like this, you want wiggle room.

Kash finds a Bloomberg report that emphasizes the market's rather optimistic take:

Bonds and stocks rallied as some traders read the change as a signal that the Fed will consider cutting rates by the June policy meeting. Other economists said the new wording doesn't necessarily mean a reduction is imminent.

"It does not appear the committee is prepared to consider easing; rather, they are ruling out tightening," said Chris Low, chief economist at FTN Financial in New York. "The FOMC concedes a decidedly gloomier economic picture in March than in January, but continues to worry" about inflation.

Ruling out tightening? Ah, no. (See above.) Kash adds his comments,

I think that Chris Low's reading at the end of this excerpt is spot on: today's statement may indicate that a rate hike is not in the offing, but does nothing to indicate a rate cut any time soon. That's why I think the markets' exuberant reaction (or should that be "irrationally exuberant"?) today will likely be largely undone tomorrow, as a more sober assessment concludes that since we already knew that a rate hike was not likely, this was not really news.

At first I also thought that tomorrow the gains of today would be reversed. I mean, that would be the normal thing to expect. But the markets have displayed something of a disconnection from reality in the last few months when it comes to understanding the Fed's position. Am I to expect that they will figure it out tonight? Anything is possible. And it is fun to sit here the in the evening and predict where the market will go tomorrow, especially if there is a logical basis for that prediction. But I would not be too surprised if the market takes a few days to chew this over.

And I do think that this statement was news, just not in the way that many on Wall Street first thought.

As they say, save the tape, we may want to replay this later.

Posted by William Polley at 2:47 PM | Comments (0) | TrackBack

February 21, 2007

FOMC minutes: The message is clear

Here's the link to the minutes. Scroll about halfway down to get past the formalities of the first meeting of the year. I will focus on this part:

The FOMC's decision at the December meeting to leave its target for the federal funds rate unchanged and to retain the language in the statement regarding the risks to inflation appeared to match investors' expectations. However, the characterization of recent economic growth was reportedly interpreted by market participants as suggesting a slight softening in the Committee's outlook for the expansion. As a result, the expected path of the federal funds rate beyond the near term edged down. The subsequent release of the minutes from the meeting elicited little market reaction. Investors' outlook for economic activity firmed over the intermeeting period, as economic data releases came in stronger than expected and oil prices declined notably. As a result, investors markedly reduced the extent of policy easing anticipated over coming quarters, and yields on nominal and inflation-indexed Treasury coupon securities rose. Measures of inflation compensation were little changed on net. Spreads of investment-grade corporate bond yields over those of comparable-maturity Treasury securities moved down a bit, while those of speculative-grade issues declined significantly more. Broad equity indexes edged higher. The foreign exchange value of the dollar against other major currencies rose, on balance, particularly versus the yen.

I believe we covered this ground back in December when I said,

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

Anyway, back to the minutes...

All meeting participants expressed some concern about the outlook for inflation. To be sure, incoming data had suggested some improvement in core inflation, and a further gradual decline was seen as the most likely outcome, fostered in part by the continued stability of inflation expectations. However, participants did not yet see a downtrend in core inflation as definitively established. Although lower energy prices, declining core import prices, and a deceleration in owners' equivalent rent were expected to contribute to slower core inflation in coming months, the effects of some of these factors on inflation could well be temporary. The influence of more enduring factors, importantly including pressures in labor and product markets and the behavior of inflation expectations, would primarily determine the extent of more persistent progress. In light of the apparent underlying strength in aggregate demand, risks around the desired path of a further gradual decline in core inflation remained mainly to the upside. Participants emphasized that a failure of inflation to moderate as expected could impair the long-term performance of the economy.

Clear enough for you?

In other news... (Reuters)

WASHINGTON (Reuters) - Higher-than-expected U.S. consumer prices last month chilled hopes that the Federal Reserve will drop a policy bias to hike interest rates and served a terse reminder that inflation remains a threat.

Economists said the rise would not prompt immediate action from the U.S. central bank, which has voiced guarded optimism that price pressures were heading down, but it reduced the likelihood that the Fed will cut rates any time soon.

"It appears that the deceleration in core inflation that was evident in October and November has come to a halt," wrote Morgan Stanley economists David Greenlaw and Ted Wiesman.

...

The Department of Labor said on Wednesday that the Consumer Price Index rose 0.2 percent in January, while the core non-food, non-energy index climbed 0.3 percent.

In both cases, the rise was one-tenth of a percentage point higher than forecast by analysts, lifting the gain in core CPI since January 2006 to 2.7 percent. This is well above the comfort zone voiced by a number of Fed policymakers for core inflation to remain in a range of 1 percent to 2 percent.

The Conference Board's Leading Economic Indicators was up, but by less than expected.

No reason to expect any change in rates at the next meeting, at least not at this time. All signs point to a positive but slightly below average year for growth with inflation not yet fully whipped. Of course, the Fed cannot target the specific reason(s) for growth being below average. If the housing slowdown is one of those reasons, it could be argued that the Fed should keep its hands off the throttle unless there was a danger of systemic risk, which I don't see at the moment. Therefore, it's a pretty good bet that the anti-inflation bias will remain at least for a few more months.

Posted by William Polley at 2:17 PM | Comments (0) | TrackBack

February 13, 2007

The Fed's greatest hits of 1978

Washington Wire informs us that the Federal Reserve has released their transcripts from 1978.

[G. William] Miller, probably unknowingly, made what may be the most accurate observation about the U.S. economy and monetary policy in the late 1970 at the conclusion of the October 1978 meeting. After hearing the federal funds and monetary aggregate preferences of each member, Miller quipped, “Well, thank you all. Let’s see what we have. A mess.”

My list of things to read grows longer.

Posted by William Polley at 4:25 PM | Comments (0) | TrackBack

January 31, 2007

Fed leaves rates unchanged; GDP up 3.5%

(FOMC press release)

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

Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. Overall, the economy seems likely to expand at a moderate pace over coming quarters.

Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time. However, the high level of resource utilization has the potential to sustain inflation pressures.

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; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Cathy E. Minehan; Frederic S. Mishkin; Michael H. Moskow; William Poole; and Kevin M. Warsh.

Mark Thoma summarizes the differences word-for-word. There are a couple of significant changes in the language.

First, they state that "some tentative signs of stabilization have appeared in the housing market." I know some commentators would disagree with that, but by putting this into their statement it conveys that the FOMC is less concerned today about the possibility of housing dragging the economy down than they were six weeks ago. In the same paragraph, they removed the words "on balance" from the last sentence. I would interpret this as meaning that they are more confident that the economy is now, to use a colloquial phrase, "firing on all cylinders."

They are still "two-handed" on inflation, but the hands have switched places. Look closely and see what I mean. In December they said:

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.

Translation: On one hand, inflation pressures still exist. On the other hand, lower energy prices, past rate hikes, etc. may cause inflation to moderate.

Today they said:

Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time. However, the high level of resource utilization has the potential to sustain inflation pressures.

Translation: On one hand, inflation pressures have been moderating. On the other hand, high levels of resource utilization (i.e. strong growth) may lead to a renewal of inflation pressure.

Rhetorically, people (economists included) often use the construction of the "other hand" to indicate something that could happen but is less of a certainty. Read that way, this is encouraging news indeed.

In the next paragraph, they drop the word "nevertheless." Let's not over-analyze that.

It was unanimous, but that was anticipated given that the rotation of the voting members. Mr. Lacker is not voting this year. I do wonder if, given recent data, he would still want one more increase or if he has moderated his stance.

Based on this, and the solid (not stellar, but solid) GDP report today, I don't look for any change in rates for some time. New data could always change that, but right now it looks like it's "steady as she goes." A couple more data points in favor of a soft landing.

For more, read Reuters and the Wall St. Journal reports on GDP.

Posted by William Polley at 2:42 PM | Comments (1) | TrackBack

January 30, 2007

Rate hike in '07 more likely than a rate cut?

The fed funds probability charts at the Cleveland Fed now indicate that a rate hike is more likely than a rate cut in May. The market is still predicting that the Fed will keep the funds target rate at 5.25% with near certainty at the next two meetings. It is less certain about May, but if you predict movement either way, you're still facing pretty long odds.

It's a quantitatively small shift, but represents a growing sentiment out there that those rate cuts that a lot of folks were counting on in 2007 may not materialize. It's a turnaround from early December when speculation of a rate cut at its height. It was to the point that I couldn't ignore it but I was really torn. Here's what I said on December 7:

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.

Thank goodness for my inner Cassandra for keeping me from jumping all the way on that bandwagon.

So will we get a clue from the statement tomorrow as to which way things will break? Possibly. As Reuters reports:

Economists polled by Reuters forecast the economy grew at a 3 percent annual rate in the fourth quarter, rising from the 2 percent growth pace of the previous quarter.

Tomorrow we will know. And a statement from the Fed highlighting prospects for this pace of growth for 2007 will be interpreted as a sign of higher rates to come. But the price of oil remains a wild card. Low oil prices could keep the Fed content to remain where they are. The funds rate could stay at 5.25% all year as inflation pressure continues to abate and real GDP hits the sweet spot of 3% growth.

I believe that would be called a soft landing.

While it may be a bit premature to be calling a soft landing already, it's not too early to start establishing some criteria. What will you call it if real GDP growth is around 3% for the next two or three quarters while core PCE inflation drops below 2% and job growth averages between 125K and 150K per month? Are those appropriate criteria?

Let's see what tomorrow (Fed and GDP) and Friday (employment report) brings.

UPDATE: In related news, Bill Conerly looks at the data on housing vacancies and cannot dismiss that the possibility of recession still hangs over our heads. Calculated Risk worries about a nationwide fall in home prices this year, but gives Bernanke credit where credit is due.

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