Friday, September 29, 2006

Neutral Is Neutral Is Neutral Until It Isn't

As I wrote last night, Bill Poole, President of the St. Louis Fed, was going to feed us what the Fed has been feeding us: The funds rate is at neutral until the data prove that it isn't. Between the lines, there is a bit of a wink to the expectations that an ease next year is not out of the question but he also lays out the parameters;

If incoming economic indicators show that both output and inflation are rising above these forecasts, then in the absence of any other information we can expect that the FOMC will increase its target fed funds rate. On the other hand, if both output and inflation come in weaker than expected, we are unlikely to see further increases in the federal funds target; indeed, if economic weakness is pervasive enough the FOMC will at some point reduce the target funds rate.

The italics are mine.

Where is the wink to an ease next year?
If the economy comes in below the baseline forecast in coming quarters, the FOMC will have room to act as aggressively as required. I have no idea what scale of easing might be appropriate, for that will depend on the nature of the incoming information. Still, I believe forecasters should assign a relatively low probability to deep recession precisely because of the FOMC's demonstrated willingness to act aggressively as necessary.

So the Fed isn't expecting an upturn anytime soon, and while they expect the economy to slow to a less than 3% real growth path (the new non-inflationary trend path), if the wheels come off the proverbial bus they will be on it quickly -- there is no gradualism on the downside

As for market thinking, Poole notes:
The market's evaluation of the prospects for policy is revealed in the futures markets for federal funds and Eurodollar deposits. Current futures prices predict that the fed funds target is expected to begin moving down. . . . the market's expectation of future policy easing has been taking hold gradually since late June, say, in response to data on the real economy suggesting that real growth is slowing and inflation data suggesting that the worst may be over on that front.

Is the market right?
I want to underscore my earlier point about the limited accuracy of those forecasts. Some of the forecast misses have been pretty dramatic.

When the market has been wrong, it is generally when:

Both the FOMC and the markets were surprised by incoming information . . .

According to Fed studies, 70% of the difference between the Eurodollar futures market forecast for rates six months out and where rates acutally end up is explained by "no one saw it coming". Remember that when street people write with rock-solid confidence what is going to happen next and what the Fed will do about it.

The market overreacts to every data point, it has to. The street only gets paid when money changes hands, so getting everyone on edge about the importance of the next data release is part of the drill. Remember when it was the money supply data on Thursday night? Remember money supply?

Anyway, the Fed, being professional has no panic, professionals never do, which is why Poole says:
. . .it is rare that a single data report is decisive. The economic outlook is determined by numerous pieces of information. Important data such as the inflation and the employment reports are cross checked against other information. . . .

. . . .Policymakers piece together a picture of the economy from a variety of data, including anecdotal observations. When the various observations fit together to provide a coherent picture, the Fed can adjust the intended rate with some confidence.

As for my neutral is neutral until it isn't, Poole closes with:
That the policy setting is data dependent is a good sign. It means that policy is in a range than can be considered neutral that is, thought to be consistent with the Fed's longer-run policy objectives. . . . I believe that is just about exactly where we are today.

That may be where the Fed is, but not the market. As I wrote yesterday, Poole was going to disappoint the market by telling the grand poobahs of market opinion that he isn't ready to ease. It was predictable, as is the market's reaction. The 2-year Treasury is currently up 3.5 basis points on the day, 5's are up 4.3bps, and 10s are 3.7bps. The movement reflects the red Euros being down 3 to 4 basis points.

Even with this back up, the market is still pricing in 25% chance of an ease in Jan, around 25% to 30% in Mar and 40% in May. Pretty high odds considering Poole's comments. If you own the 2-year Treasury you own those odds. To give a sense of the risk, if the expectations went to 0% the 2-yr would back up near 60 basis points in yield.

I am predicting nothing but expecting anything. Odds of an ease are better than they are for a tightening, but the market is just too sure for me that the economy will need lower rates to avoid recession. May turn out to be true, and the Giants might win the Super Bowl, but how much do you want to bet on the outcome?

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