Monday, July 31, 2006

Poole Speaks/Yellen Confirms/The Game Is Afoot

Poole has spoken -- he is officially 50/50 on whether the Fed should go or not. The remarks were made today, post a speech he made "Chinese Growth: A Source of U.S. Export Opportunities" in Lousiville, Ky. Poole pointed out that more incoming data between now and August 8 will be critical, such as Friday's employment report. Yellen gave a speech today at the Golden Gate University Speakers series and said the same -- 50/50. The game of managing the markets expectations as evidenced by the Fed funds futures market has begun.

The Fedspeak may be 50/50 , but the market remains at only a 26% likelihood they tighten in August and then nothing until they ease next year. The bond market, in its infinite wisdom and led by their chief spokesman Bill Gross, has voted that the bear market in bonds is over for this cycle. To give Bill his due, not that he needs it from me, he is a longer term bear for many of the same reasons I am -- the need to inflate is greater than not (opposite of 1979).

Strange, however, that the market is more certain than the Fed that August is a no-go, at least by virtue of public statements. If the Fed wants to move the market back to 50/50 look for an Ip article today or tomorrow.

To put the current market in expectations in some context let me trace today's comments from Yellen and Poole back to Bernanke's testimony on July 19, when he stated:
"In particular, we have imperfect knowledge about the effects of our own policy actions as well as of the many other factors that will shape economic developments during the forecast period. . . . . effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic growth. In formulating that outlook, we must take account of the possible future effects of previous policy actions--that is, of policy effects still "in the pipeline." Finally, as I have noted, we must consider not only what appears to be the most likely outcome but also the risks to that outlook and the costs that would be incurred should any of those risks be realized.

At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as provisional and subject to revision as the facts demand."

Which facts? Employment and CPI data? At this stage of the cycle greater import is given to anecdotal information than not -- the Beige Book. The reason to rely on anecdotal data was specifically laid out in Poole's speech at a Bank Of Korea Conference on June 16, "The Role of Anecdotal Information in Monetary Policy" If you want the academic model for how the FOMC should be analyzing the current environment read "Real-time Model Uncertainty in the United States: The Fed from 1996-2003" by Tetlow and Ironside.

The Fed is looking at the entrails of the data coming in. The Fed is making lots of phone calls to the business community. They are trying to figure out whether the economy is at the point where they should trust their forecast and believe the moderation story (see my last blog "White Kunckle Time for Bernanke").

There is another item that helps put today's comments into some context. Prof. Mishkin's paper "Can Central Bank Transparency Go Too Far?". If you can't wait for the movie, the essence of the paper is that at some stage policy is more effective if policy moves are unknown in the short-term against the market's understanding what the longer-term goal is, assuming that the central bank has established credibility -- through previous communication and action. Prof. Mishkin is now on the FOMC. The move from transparent communication to opaque has begun.

In sum, the market thinks it sees through the opaque policy statements to believe that the data and building anecdotal evidence (best shown in the beige book) mean that August is a no go. If the Fed does go, the markets will probably rally anyway, believing that they went too far. This is one case where I believe the market is right in anticipating a no-go. My impression is that the Fed is much less certain than the market than an ease next year is baked in the cake. Perhaps that is the message they are trying to get across.

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