Monday, December 04, 2006

Why Not Ease In Dec? Kohn Tells Us Why They Could

In remarks by Vice Chairman Donald L. Kohn at the Fourth Conference of the International Research Forum on Monetary Policy on December 1, Kohn gave out the rationale for moving to a neutral bias at the Dec meeting or even ease. Here is, in my humble opinion, the critical paragraphs (as always, italics and bolds are mine):

"An important source of our uncertainty about the recent past and the current state of the economy is that economic data typically come in with a considerable lag and are subject to substantial measurement errors and revision. . . . academic economists may still not fully appreciate the degree to which measurement uncertainty bedevils policymaking. These difficulties are especially pronounced at times like the present. . . .

Consider our estimates of real economic activity. These estimates often change markedly with the receipt of just a few more days or weeks of data."

WOW!!!!!!!!!!!!!!!!! Estimates can change markedly with a few more days or weeks of data? Less than 10 days to the FOMC for Dec with Nov employment smack in the middle. And Poole told us one data point doesn't matter. It matters if it completes a picture drawn from all the other data.

How does Mr. Kohn deal with this uncertainty?

"Given that uncertainty is pervasive, how should central banks deal with it? . . . . cost-effective ways to support both the development of more accurate and timely data . . . . using data in a nuanced manner--. . . . being cautious about the weight placed on short run movements. . . . . such efforts can take policymakers only so far. . . . risk is unavoidable, and central banks need to conduct policy in a manner that takes account of uncertainty in its various forms, as they strive to maximize public welfare."

Later in the talk:

". . . gradualism and model averaging may not be appropriate in all circumstances. . . . may be necessary for monetary policy to respond to what might be called "tail events," . . . choosing policy settings to minimize the maximum possible loss across different models of the economy, in contrast to . . . . minimize the average loss across models. . . . policymakers may at times base policy settings on especially pernicious risks has an important ring of truth."

Kohn goes on to say:

". . . central banks now strive to conduct policy in a predictable (albeit flexible) manner that is consistent with their stated objectives. On occasion, however, the goal of predictability may conflict with the concept of risk management, particularly when risk management requires taking steps to deal with an unusual or unprecedented risk. "

So if the data come in weak in the next few days, how does Kohn plan to conduct himself at the FOMC meeting:

". . . . heterogeneous viewpoints expressed by my fellow Committee members are intellectually stimulating and that they spur me to improve my own thinking about the economy and about the best course for monetary policy."

This from a man who two months ago wondered why the market was so certain that the Fed would be easing in 2007 and cautioned against shorting the Fed's resolve against inflation. Like Keynes and any rational person, and Kohn is certainly rational, new information changes his mind.

Where does that leave us now that the divine prophet of the Greenbook has told us that its tough to run policy from the data? Given Bernanke's remarks (see previous post) and remarks from others, a netural bias is in the bag.

The question before the FOMC is this: If the economy seems weaker than they expect, why would they wait until January 31 to ease? They wouldn't. This is why all the talk has been a mix of maybe things are softening with everything is runnning according to plan and the "We are fighting inflation" credibility mantra.

Without the positive talk, the FOMC is in that "why wait and ease now" bind. On the one hand, on the other hand, so we wait some more but give an acknowledgment that the economy may be a tad worse than expected. No wonder Truman wanted a "one-handed economist".

From a market perspective, the answer is pretty simple, buy the Dec Eurodollar futures outright. (Remember this is my opinion, not a recommendation to do anything other than to think about how the market is priced, the appropriate trading or investment opportunity for you is for you to decide) It is trading at 94.66 when 94.63 is "Fed on hold". The market's odds of Jan ease is around 20%. Or you can buy some out-of-the-money calls on Dec Euros or calls on Feb Fed funds (Jan/Feb spread doesn't work if they ease before the Jan 31 get together).

The FOMC might just ease in Dec or before the Jan meeting. As I wrote back in the summer, its "white knuckle time" for Bernanke.


Anonymous said...

I think this explains why the market's already price in a cut by March

Anonymous said...

Why do you think the Fed Governors keep insisting inflation's the larger worry ??? it seems that they are embarrassing themselves as the data proves them otherwise

Tax Shelter said...

It is obvious to me that the Fed should ease, for the fed fund rate is too high. If the Fed eases, then contrary to the conventional wisdom, I believe it is likely that the dollar price of gold will fall while the dollar will at least stabilize. But will the Fed do the right thing? The next two FOMC meetings will show us if the new Bernanke Fed knows what it is doing.