Monday, June 19, 2006

Bernanke leads the way again....with an interesting add

Bill Poole's most recent talk at a Bank Korea Conference on June 16 makes for fascinating reading. He often says what Bernanke can't, or at least shouldn't say directly. The main thrust of the speech is that the FOMC can and often should rely on anecdotal information well before the official stats in determining the course of policy. The following paragraph from the speech is a good summation:

"In the absence of precise statistical forecasting models, another potentially useful source of information to assess the stability of inflation expectations and the likely course of the real economy is real-time anecdotal information. The drawback of anecdotal information is that there is no scientific basis for the sample. Yet the accumulation of forward-looking anecdotal information at critical times can be informative. An example can be drawn from the recently released transcripts of the FOMC meetings of October, November and December, 2000. At that time, the best inference from statistical forecasting models was that economic growth in the U.S. would gradually slow from the very high rate of the first half of the year to rates that were regarded as more sustainable. Yet, also at that time, more and more FOMC participants were reporting stories indicating sharply slowing conditions from an ever increasing number of respondents. We now measure real growth in the second half of 2000 as less than 1 percent (annual rate), with negative growth in the third quarter. In this instance the anecdotes gave a better early warning signal of the turn in activity than did the forecasting models."

In other words, also from the speech:

"A similar situation may prevail today. Statistical studies to detect pass-through from recent energy price increases have failed to show significant effects in U.S. price data but stories about widespread pass-through are becoming increasingly common. We may—and I emphasize “may” because my purpose is to make a general point and not to conduct a full analysis of the current situation—face more inflation pressure than currently shows up in formal data."

Meaning -- Fed in August is pretty clear unless there is a collapse in final demand. Possible but today's Beckner article puts the Fed's perspective on going too far in a clear light:

"Despite 400 basis points of tightening, the Fed does not regard overall
credit conditions as being restrictive. There is ample liquidity to fuel
continued expansion in a resilient economy that has often outperformed

Even if it believes the tinder for an inflation flare-up is lacking and
that the recent bulge in inflation is fundamentally transitory, officials
stress that they must guard against letting inflation expectations take on a
life of their own and fuel an acceleration of actual inflation.

So the prevailing Fed view is that this is not a time when the Fed
should take chances with inflation.

If need be, rate hikes can be reversed. The Fed can and will undo rate
hikes that later prove to be unnecessary, and it is hoped that the markets'
knowledge of that possibility would tend to cushion the impact of further
rate hikes."

As I have been writing, only the "Street" thinks money is tight. A piece written by Stephen Cecchetti of Brandeis University, breaks down the recent CPI numbers and stated that the Fed is now going to 6%. He is right in assuming that 6% is the beginning of tight money. The world is at least beginning to migrate to my view that there is much more to come before credit is constrained and an immediate collapse in growth, at least from the credit side, is not forthcoming.

In sum, the Fed has officially let us know that if the anecdotal evidence points to inflation, they aren't waiting for the data. They have more to lose by waiting and allowing inflation expectations to become unglued than by going too far and then reversing and, as Beckner notes, hoping the market recognizes this flexibility in Fed policy. Does the Fed really want to go so far as to constrain credit and risk recession? At what point does nominal GDP growth drop down to the funds rate and at what point do they stop and wait? Based on this new information, they won't. They are intent on moving forward regardless. We will see. Tough talk oftens hides an easier policy and the Fed, since 03, has been very easy.

But the real news with the Poole speech, at least to me, is that he has brought money supply growth back into the picture.

"The observation that correlations are changing or disappearing does not mean that the economy has fundamentally changed. In particular, it is likely that the correlation between the growth of monetary aggregates and the inflation rate (or even nominal income growth) will be small in low inflation environments. Yet central bankers who fail to monitor the growth rates of monetary aggregates do so at their own peril. History illustrates that rapid and accelerating monetary growth, positive or negative, is a recipe for the demise of the low inflation regime into inflation or deflation. Just because a low inflation environment has been established, central bankers cannot print money without restraint. Large correlations, then, provide evidence that the central bank has failed to exploit relevant information; as policy becomes more effective, correlations tend toward zero."

Why news? First time in a long time that the Fed has mentioned money supply. Also interesting is juxtaposiing his comments with the recent behavior of money as we can easily see in the St. Louis Fed Publication on U.S. Financial Data. Isn't that the place Poole runs? Anyway, the data show that monetary growth is not accelerating and seems to be plateauing, same for credit demands. This may be a bit seasonal but the inclusion of money into the speech at this moment suggests, perhaps only to me, that the Fed is going to listen to gossip and rumor in determining whether to tighten further while ignoring money supply -- if it is slowing down while inflationary evidence is on the rise.

So, if Keynes once changed his mind when he got new information, who am I not to take this new and take a step back from "August And Done". Holding at 5.5% now seems less likely. Moving to 6% is becoming more likely. I have written that 6% was the beginning of truly tight money, questioned the politics of really going after a slowdown in growth. Is there a value in shocking the market with a suprise 50 if things don't ratchet down by the early fall? Perhaps they recognize what Greenspan left them and realize they have no choice.

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