What Is The Market Thinking Now

Based on the Fed funds digital options trading on the CBT, that collection of wisdom from the maelstrom of fear, greed, and uncertainty, is pricing a 20% probability of the Fed raising rates at the September meeting (Sep 20, for those of you planning any vacations). After that point, there is no sign of Fed activity until early next year when the collective wisdom is pricing in an ease. When all is said and done, it looks like 50 bp over the next year.

I am not sure whether market participants are thinking at all. THE FED WILL NOT TIGHTEN IN SEP. The only thing they will do aside from nothing is an ease if the data indicate an imploding economy. Once Bernanke put the Fed forecast on the line there is no way he can change direction with six more weeks of data. The October meeting, a different story but only marginally so.

The reason is that the Fed, like the Supreme Court, has its traditions, its playbook, its way of doing business (so to speak). An excellent read on this is A Term At The Fed by Laurence Meyers. The Fed doesn't flip flop like traders and commentators, they hold to their position for a while before shifting -- unless some major exogenous event (9/11 for example) takes place. Consequently, pricing in any chance of an ease after they just skipped is just silly.

There is yet one more reason why a skip is unlikely -- the dropping of the productivity reference. Productivity always falls late cycle because growth slows while employment, which lags, is still on the upswing. The dropped reference is not an attempt to say that productivity is no longer going to bail out price pressures, as some have suggested, but acceptance by the Fed that the economy is in a late cycle mode. This plus the skip is a bit disquieting if you are an economic bull.

The Fed has done research on what went wrong with policy in 2000. They came away with the idea that there are times, particularly turning points, when anecdotal information is of more value than the official data driving the model (see also the Poole speech that I am always referencing).

What is the upshot? Anecdotal information gave Bernanke confidence in his outlook to stop. Losing the productivity reference is his way of telling us that he believes we are in a late cycle. The Fed doesn't like what it sees as far as growth prospects are concerned, more than they are letting on (regardless of the dissenting vote, which suggests that he doesn't think slower growth will slow inflation). The equity market, picking up on this, has sold off. The geniuses in the bond market are still pricing a 20% probability that they tighten in September. Go figure.