Wednesday, October 25, 2006

Pre-FOMC Is Said and Done, And To Be Said Again -- With A Twist

No sooner does the Fed get through telling the market it can't understand why the certainty of an ease is priced in for next year when the savants raise market yields to the point where they are pricing a small risk of a tightening in Jan -- but still expect 25bp of an ease by Sep 07 and 50/50 of another 25 in 08:1Q. Market opinions swing and generate trading, but in truth there isn't much to do except wait for the unexpected to move the Fed to ease or to tighten.

To sum up current pricing, before today's statement, the market is giving up a tiny risk premium, about 12%, that the Fed tightens by Jan. This is more insurance premium than anything else. The world is long cash and the risk of moving to "on hold" is at least 20 basis points in the 2-year.

After Jan, the expectation is that slower growth reduces inflationary pressures and, as such, gives the Fed leeway to drop funds 25 to 50 basis points.

Perhaps yes, perhaps no.

The market has to express some opinion but here is the Fed's (from my perspective): Everything is fine for now, when the unexpected occurs we will react, the longer time goes on the greater the possibility for the unexpected. Which way will it pull the Fed? They don't know. We don't know. The market really should have a flat curve. Anything else is a bet on a random event.

John Makin, an excellent economist (meaning that I agree with him more often than not), lays out the cross-currents that have the Fed waiting for events to unfold before doing anything. In his Economic Outlook column for the AEI. Lifting from piece, entitled "U.S. Slowdown Self-Correcting or Self-Reinforcing":

"The U.S. economy’s capacity for self-correction, whereby a slowdown of the real economy creates financial conditions that support an economic rebound, has been in no small part responsible for its remarkable resilience--especially over the last half-decade. .....

. . . . . As we enter the fourth quarter of 2006, the economy’s self-correcting mechanism is easing financial conditions and mitigating the drag from an intensifying slowdown in the housing sector, even though the Fed has signaled that it may continue to raise the fed funds rate if inflation persists. The operation of those opposing forces has created considerable uncertainty about the outlook for U.S. growth. . .

. . . . The notion that the slowdown may be self-reinforcing is underscored by the fact that actual weakness in the housing sector is probably more pronounced than the official data suggest. . .

. . . . .The balance between self-correcting and self-reinforcing slowdowns appears recently to have shifted slightly in the direction of self-correcting. . . . . .

. . . . . .What then is the likely outlook over the next year? Will self-correcting or self-reinforcing economic slowdown forces dominate? The two opposing forces have to remain about balanced with a tilt toward a self-reinforcing slowdown to validate the market’s current assessment that the Fed will start easing during the first half of 2007. Perhaps the most likely outcome will see growth oscillate gently around an underlying negative trend tied to a persistent drag from the housing sector. . . . . ."

This is what the Fed thinks, as Poole and Kohn and Yellen and everyone else has told us.

Thoughts for today's statement? A more balanced assessment of the risks going forward. The Fed likes the idea of keeping funds at 5.25% in the short run and letting the long end soften the blow to housing. Not too low, of course, and not too high (which is where the market might be going). So we get a responsible statement that lays out the risks and determines that there is nothing to do until the unexpected happens.

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