Monday, November 06, 2006

Fed Fixes Market Focus . . . . . .Again

The monthly cycle to bring the market savants back to reality has begun. The Fed, again playing the role of responsible adult, is letting everyone know that the economy isn't tanking, the Fed isn't easing, and the risk of inflation is greater than that of a recession. The program to redjust attitudes and pricing began with the Beckner article on Friday (see my previous post) and Moskow's talk in Chicago this morning. Tonight (10pm est), Yellen speaks. Before the parade is over Poole will pop up to put the final coda on all of this.

The market, stubbornly holding to the view that its take on the economy is more correct than the Fed's (sometimes it is, this time it isn't), used Friday to push out the first ease to June. Apparently an ease delayed is not an ease to be denied. If anyone was really thinking, they might conclude that the tough Fed talk is masking an easy policy that is going to have to tighten late next year -- not ease. On that point, follow below through the highlights (as I picked them) from the Michael Moskow, President of the Chicago Fed, speech this morning to the Chicagoland Chamber of Commerce on the U.S. Economic Outlook.

Since so many are focused on a 5.25% funds rate demolishing the housing market and, in turn, the source of consumer spending, here is the Fed's take:

"A significant part, though, was due to developments in the housing sector. Residential investment has fallen 7-1/2 percent year-to-date, and in the third quarter it shaved 1.1 percentage points off of GDP growth. Additionally, home prices have been rising more slowly and by some measures have even declined. These developments raise important questions for the economy as a whole: Will there be further declines in housing markets? And will the current and any further declines in housing lead to more general economic weakness? . . . .

. . . . Nonetheless, with underlying housing demand growing 3 percent per year, the large gains in residential investment—which averaged 8-1/2 percent per year between 2001 and 2005—clearly could not continue indefinitely. Moreover, housing demand may slow to less than 3 percent, as demographics point to slower growth in household formation. As a result, we at the Chicago Fed expect some further weakness in residential construction.

.. . . . Currently, we do not see the slowing in housing markets spilling over into a more prolonged period of weakness in the U.S. economy overall. On balance, the 95 percent of the economy outside of housing remains on good footing. Employment has been increasing near its long-run sustainable pace. Productivity trends remain solid. Recent declines in oil prices should give household budgets a boost. Economic growth in other countries should increase demand for our exports. And current financial conditions are not very restrictive by historical norms."

Please note the phrase that I bolded and italicized. FINANCIAL CONDITIONS ARE NOT VERY RESTRICTIVE BY HISTORICAL NORMS. Ok then, if that is the case and the economy is expanding, what is the inflation view? From today's speech:

"Still, there is a risk that core inflation could run above 2 percent for some time. We could be wrong about reduced pressures from resource constraints, or we could see further cost shocks. And perhaps most importantly, if actual inflation continues at high levels, it could cause inflation expectations to run too high. If firms and workers expect inflation to be high, they will want to compensate by raising prices and wages or building in plans for automatic increases. In this way, high inflation expectations can lead to persistently high actual inflation."

Therefore, the conclusion on policy:

"Taking all of the factors on growth and inflation into account, my current assessment is that the risk of inflation remaining too high is greater than the risk of growth being too low. Thus, some additional firming of policy may yet be necessary to bring inflation back to a range consistent with price stability in a reasonable period of time. But that decision will depend on how the incoming data affect the outlook."

The Fed speaks, the market should listen. As for investors, 25bp in risk in the two-year Treasury if the market just goes back to pricing 0% odds of the Fed doing anything.

If, at the January meeting, the Fed holds because Christmas was good and the algebra of GDP growth makes for a stronger 4th quarter, those back Euros will be trading to a tightening instead. Just an opinion, but remember Moskow told us growth is fine and policy isn't particularly restrictive. Folks, the longer they stay on hold the less restrictive policy becomes. The nature of this economy is adapt and grow not shock and fold.

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