Friday, June 30, 2006

Bernanke Opts For Mishkin For FOMC -- A Turn For Monetary Policy?

I wasn't planning on writing anything today, but the Mishkin appointment has made me do it. He is obviously academically qualified and of the same inflation targetting mindset, this is beyond debate. What is interesting about the appointment, and it is a good assumption that Bernanke wanted him for the FOMC, is his paper "Can Central Bank Transparency Go Too Far".

Here is Mishkin in his own words in the abstract:

"This paper argues that some suggestions for increased transparency, particularly a central bank announcement of its objective function or projections of the path of the policy interest rate, will complicate the communication process and weaken support for a central bank focus on long-run objectives."

Have a good holiday weekend, more on this next week.

Thursday, June 29, 2006

What The Fed Said

Parsing through an FOMC statement is always fun, this time it is also interesting. The Fed has moved from forward-looking statements on inflation, resource utilization, and the moderation in growth, to the here and now: Inflation is up, resource utilization is high and growth has moderated. Last month they wanted to emphasize that future Fed action would depend on data, this month the FOMC dropped the word “emphasis”. My guess is that they believe the market finally understands that a pause is not necessarily forever or tacit admission that they went too far. As far as the shift to the present in terms of describing the economic landscape, the FOMC is telling us that if growth is to pull down or at least temper inflation expectations it is going to occur in the next several months. If not, the doves lose and more tightenings are sure to come.

So now it is “wait till August” and the data that are collected between now and then. But if you read the Poole speech to the Korean Bankers and a recent Fed paper, “Do Macro Variables, Asset Markets, or Surveys Forecast Inflation Better?” (Andrew Ang, Geert Bekaert, and Min Wei) one recognizes that what Bernanke et al will be watching are the surveys and the anecdotal and not necessarily the published data.

In sum, the odds are 50/50 for August, though the market has, in its infinite wisdom, has decided that after August the Fed is done and the eases begin a year from now. What the Fed wants is to recapture its position in the mid 90s – no activity for a long period of time. Rates are probably too low for that, but they are balanced against high, and here to stay high, energy prices. The mix is interesting, the cross-currents are many, but there is one thing we can be sure of -- if the market starts pricing in the odds of Fed activity that is well off from where the Fed thinks they should be, they will let us know.

Tuesday, June 27, 2006

Bernanke Berry Blurbs -- Whats a Chairman to do?

A brief note coming into the Thursday FOMC meeting, or really the statement. The Berry article today was, I believe, an attempt to tell the market that if we stop, it doesn't mean we can't start again and please, please, please understand that it doesn't mean we are soft on inflation. So lets keep rates up and not let the curve invert (which really means the market betting on an ease next year).

A halt does mean that its time to step back and see how the patient is doing. At the broad level, all this makes sense. At first, the economy needed some hand holding as the Fed started to lift rates from 1% to where we are now. The recovery seemed fragile -- animal spirits were burdened by too much debt leveraged off of assets that deflated. Now that we are several years into recovery and rates are about 150 points below nominal growth, there can't be a road map for whats next -- the economic outlook is uncertain. There can be an understanding that the Fed is resolute in allowing real growth but squashing activity that smells of inflation expectations, hence the Berry article. We all know that investors don't like uncertainty and brokers love it, so the Fed clearly helps investors between the meetings by letting us all know how they are viewing the data and its influence on policy.

What Bernanke wants as the end to this current game is credibility and for rates to level out so they and the economy can behave more like 1996/97/98. It was then that Greenspan found the new economy, we found goldilocks, the Fed raised rates 25bp once in that period -- at the Mar 97 meeting. During that whole time, Greenspan was running counter to the wise wall street wizards who were proclaiming that the economy was too hot, etc. for rates to stay that low and keep inflation down. Greenspan was right, the wizards were wrong. The policy did, however, create its excesses, culminating in the LTCM debacle that caused the sharp drop in rates in Sep 98.

Enough history, bottom line is that we are going to live in this uncertainty for a while. Although I think he his stopping too soon to quash inflation, it still isn't wrong for Bernanke to hold at 5.25% and wait and see. By the way, for those convinced of a pause in August and a go in Sep -- if you know the Fed is going to go in Sep, why wouldn't they just go now, or is it that your forecast is better than the Fed's? Given the track record of the street's forecasts vs the Fed, I'll bet on the Fed.

Wednesday, June 21, 2006

The Transparency Of A 50 Basis Point Move

We are beginning to see the distant rumblings of 50bp tightening suprises from "The Street". At one point there was even a near 10% probability priced into the June Fed funds contract. As I noted in a previous post, talk of a "shock 50" was bound to happpen. Such a move, however, is unlikely to occur and unlikely to get the Fed what it wants -- slower growth. Why not? In the first instance, in reaction the long end rallies and so too might the stock market, anticipating that the Fed is done and may soon have to ease. The transparent policy mantra will have everyone priced in and hedged up. A 50bp move collapses the time frame of expectations, not the final outcome.

Of course the market will be 100% wrong because the shock won't end up adversely impacting the economy at all and expectations will soon begin pricing in a string of 50bps tightenings, although not for a long enough amount of time in my opinion. If we have learned anything these past 25 years, though the street seems to have forgotten, it is that the U.S. economy is more interest rate insensitive. The level of real rates required to slow the economy has moved higher. Why? The old regulatory circuit breakers have long been deregulated and financial innovation has allowed everyone to float assets and liabilities.

So there are two issues with a "shock 50". First, market expectations adjust the whole curve rather quickly to fit the new policy and everyone borrowing against the curve adjusts accordingly. Given that the economy floats on both sides of the ledger, the net impact will be small. Second, levels are still way too low to curtail credit expansion. Other things might put a halt to borrowing and lending, but it won't be the cost of money.

Getting back to the adjustment issue, herein lies a fundamental problem with a transparent Fed at this juncture of the business cycle. Gingerly raising interest rates from a near deflationary environment required alot of hand holding, etc. in order to get rates where they needed to be without people losing confidence. The problem now is that If everyone knows whats coming, the markets price it in and businesses hedge it up. At some point, later rather than sooner, Poole will be making a transparent attempt at convincing the world that an opaque policy is the best alternative. How do you do that? Take a page from Volcker -- target reserve growth and let the market price Fed funds.

If you can no longer count on a rational and known path for funds, what then? The impact on the real economy could be negative -- if rates are high enough.

We are far from the need for any of this, which is why 50bp is far from reality. The economy is not in the midst of runaway growth. But I do know this, if you think the well-telegraphed slow but steady policy that has created the trajectory of 25bp moves followed by plateau and then ease, and all within the next 12 months or so, is going to slow growth -- think again.

Monday, June 19, 2006

Bernanke leads the way again....with an interesting add

Bill Poole's most recent talk at a Bank Korea Conference on June 16 makes for fascinating reading. He often says what Bernanke can't, or at least shouldn't say directly. The main thrust of the speech is that the FOMC can and often should rely on anecdotal information well before the official stats in determining the course of policy. The following paragraph from the speech is a good summation:

"In the absence of precise statistical forecasting models, another potentially useful source of information to assess the stability of inflation expectations and the likely course of the real economy is real-time anecdotal information. The drawback of anecdotal information is that there is no scientific basis for the sample. Yet the accumulation of forward-looking anecdotal information at critical times can be informative. An example can be drawn from the recently released transcripts of the FOMC meetings of October, November and December, 2000. At that time, the best inference from statistical forecasting models was that economic growth in the U.S. would gradually slow from the very high rate of the first half of the year to rates that were regarded as more sustainable. Yet, also at that time, more and more FOMC participants were reporting stories indicating sharply slowing conditions from an ever increasing number of respondents. We now measure real growth in the second half of 2000 as less than 1 percent (annual rate), with negative growth in the third quarter. In this instance the anecdotes gave a better early warning signal of the turn in activity than did the forecasting models."

In other words, also from the speech:

"A similar situation may prevail today. Statistical studies to detect pass-through from recent energy price increases have failed to show significant effects in U.S. price data but stories about widespread pass-through are becoming increasingly common. We may—and I emphasize “may” because my purpose is to make a general point and not to conduct a full analysis of the current situation—face more inflation pressure than currently shows up in formal data."

Meaning -- Fed in August is pretty clear unless there is a collapse in final demand. Possible but today's Beckner article puts the Fed's perspective on going too far in a clear light:

"Despite 400 basis points of tightening, the Fed does not regard overall
credit conditions as being restrictive. There is ample liquidity to fuel
continued expansion in a resilient economy that has often outperformed

Even if it believes the tinder for an inflation flare-up is lacking and
that the recent bulge in inflation is fundamentally transitory, officials
stress that they must guard against letting inflation expectations take on a
life of their own and fuel an acceleration of actual inflation.

So the prevailing Fed view is that this is not a time when the Fed
should take chances with inflation.

If need be, rate hikes can be reversed. The Fed can and will undo rate
hikes that later prove to be unnecessary, and it is hoped that the markets'
knowledge of that possibility would tend to cushion the impact of further
rate hikes."

As I have been writing, only the "Street" thinks money is tight. A piece written by Stephen Cecchetti of Brandeis University, breaks down the recent CPI numbers and stated that the Fed is now going to 6%. He is right in assuming that 6% is the beginning of tight money. The world is at least beginning to migrate to my view that there is much more to come before credit is constrained and an immediate collapse in growth, at least from the credit side, is not forthcoming.

In sum, the Fed has officially let us know that if the anecdotal evidence points to inflation, they aren't waiting for the data. They have more to lose by waiting and allowing inflation expectations to become unglued than by going too far and then reversing and, as Beckner notes, hoping the market recognizes this flexibility in Fed policy. Does the Fed really want to go so far as to constrain credit and risk recession? At what point does nominal GDP growth drop down to the funds rate and at what point do they stop and wait? Based on this new information, they won't. They are intent on moving forward regardless. We will see. Tough talk oftens hides an easier policy and the Fed, since 03, has been very easy.

But the real news with the Poole speech, at least to me, is that he has brought money supply growth back into the picture.

"The observation that correlations are changing or disappearing does not mean that the economy has fundamentally changed. In particular, it is likely that the correlation between the growth of monetary aggregates and the inflation rate (or even nominal income growth) will be small in low inflation environments. Yet central bankers who fail to monitor the growth rates of monetary aggregates do so at their own peril. History illustrates that rapid and accelerating monetary growth, positive or negative, is a recipe for the demise of the low inflation regime into inflation or deflation. Just because a low inflation environment has been established, central bankers cannot print money without restraint. Large correlations, then, provide evidence that the central bank has failed to exploit relevant information; as policy becomes more effective, correlations tend toward zero."

Why news? First time in a long time that the Fed has mentioned money supply. Also interesting is juxtaposiing his comments with the recent behavior of money as we can easily see in the St. Louis Fed Publication on U.S. Financial Data. Isn't that the place Poole runs? Anyway, the data show that monetary growth is not accelerating and seems to be plateauing, same for credit demands. This may be a bit seasonal but the inclusion of money into the speech at this moment suggests, perhaps only to me, that the Fed is going to listen to gossip and rumor in determining whether to tighten further while ignoring money supply -- if it is slowing down while inflationary evidence is on the rise.

So, if Keynes once changed his mind when he got new information, who am I not to take this new and take a step back from "August And Done". Holding at 5.5% now seems less likely. Moving to 6% is becoming more likely. I have written that 6% was the beginning of truly tight money, questioned the politics of really going after a slowdown in growth. Is there a value in shocking the market with a suprise 50 if things don't ratchet down by the early fall? Perhaps they recognize what Greenspan left them and realize they have no choice.

Wednesday, June 14, 2006

CPI Up, Markets Down, What Next?

David Altig brought out the current thinking of the Fed on inflation as written by John Berry. Basics: No inflation spiral, current level is too high but economy is moderating. Result: Another 25 in June as insurance, we will see about August. My thought: To accept this line of logic one has to be convinced that the economy is heading south and that we are witnessing the usual lead/lag relationship between growth and inflation.

Lets take another look at this inflation news for a moment and ask the question everyone assumes is not relevant: How much of our good inflation of the past decade is owed to disinflationary policies and how much to the pricing of goods and services determined outside the U.S. Counting angels on the head of a pin? Not really, because we are in an inflation targeting monetary policy and, if foreign influences dominate, which inflation are we curbing and how is it working? I understand the feedback effects, but lets just talk first order influences and leave the rest to graduate students searching for a thesis topic. Also, reading what most people write, there is alot of partial equilibrium analysis going on anyway.

So, in the 90s disinflationary monetary and fiscal policy. Budget discipline and a narrowing deficit with revenues fed, for the most part, by capital gains taxes. Monetary discipline, the spread between nominal GDP growth and Fed funds was exceptionally narrow throughout the period. Overseas? Weak oil, weak commodity prices, no real China influence (whatever happened to those Tigers?), all indicators of soft global growth.

Today, easy monetary and fiscal policies. Rest of world is growing, oil and commodity prices indicate that, as does the growth of China. Easy money? Ask any corporation or venture capitalist looking to raise funds and ask them. Are we sitting on a growing inflationary bubble that is being fed because the gdp/gdp potential gap is shrinking around the world?

Putting a disinflationary policy mix back in place in a "guns and butter" political climate is tough, so the Fed talks tougher than they are. Fed stops soon, because no one wants recession.

If there is a risk to current expectations (as evidenced in the market by people who place their bets rather than talk them) it is that the Fed keeps going because the economy keeps going. As I noted yesterday, if the CPI came in worse than expected, front end of the curve would steepen. The jun06/jun07 euro$ spread has steepend 7 basis points. That leads to what next? Of course there will be lots of talk about August and Sep in the coming weeks as new data arrive. To me, the real opportunities lie in the 07 contracts -- that is where the coming ease is priced in. Markets still want to believe the economy is grinding to halt due to tight money. In my humble opinion, the grind will occur but not yet.

Tuesday, June 13, 2006

Waiting on Inflation, Looking At the Numbers.....

Markets sitting this morning waiting for the CPI numbers. Not quite sure what it is anyone is expecting. I am not going to guess what the number will be, I will leave that to others, but I will venture to say that regardless of the number, the Fed is going in June -- that is stating the obvious. What matters most now is what string of data, over how many months, stays the Fed in August and, of increasing importance, September. The present run shows a cumulative probability of 117% tightening by August and less than 9% through the rest of the year.

So, the key really is August. If the market starts moving it to 50/50, it will pull up the probabilities of others and steepen the front end of the curve. The red Euros (not communists, or Bush voters, the next series of euro futures after the first four) will move to higher rates as well but more than likely keep their shape -- negative slope. Why? Everyone, or at least most everyones in the market, are betting that the economy will slow and the Fed will be easing.

Want to bet against the curve? Rather than playing the 2/10 curve trade, look for something interesting to do in the red Euros.

Getting back to CPI, a good number is one month, Fed needs more evidence than that, so changes nothing much. A bad number, probability of August ratchets higher.

What do I think? Economy is fine, 5.25% money is still cheap, Fed will stop soon but the economy won't.

Tuesday, June 06, 2006

The 5.25% Solution -- Fed done in June?

Ever since the Volcker era took hold, the Street sees the Fed driving the funds rate too high and about to crater the economy -- well before the Fed. They have been right a few times. This isn't one of them.

Current worries have been in vogue since at least last year, when Fed funds passed 3%. The market's predisposition has been to price in one or two more tightenings and then done and then -- when's the first ease? This pattern is like a loadstone -- no matter what happens or what the Fed says. Why? The market was convinced that the economy would slow as consumers were hurt as housing collapsed under the weight of higher mortgage rates and $40 oil. The Fed's forecast was better than the street's. Looking forward, it still is.

The market and its gurus got really worried the other week on the heels of weaker-than-expected employment data. Enough so, that the Fed had to set every one straight, again. They let us know that 100,000 new hires a month is probably right for an economy growing at 3%, and that while the economy might be moderating to where they want, the magic low 3s, there isn't much slack and inflation continues to edge up and, lo and behold, inflation expectations are moving up as well. They even trotted Greenspan out to let every one know that high oil prices haven't dampened growth. The Street seems convinced that 5.25% funds plus $70 oil means an ease beginning next week (check out the euro$ strip, its all there in black and white, black and amber(?) if you are looking at a Bloomberg).

What does it mean? Fed goes in June (every one knows that), but the opportunity is that the market believes they won't go in August. Price of Augy funds suggests no way for it to go up unless Fed eases and for it to drop almost 20 ticks if the Fed tightens -- all assuming Fed tightens 25 on June 29.

From my perspective, the Fed reaction to the employment data means it is more likely to go in August than not. Economy is fine, money is cheap, credit is plentiful, and the weaker dollar is helping capex. Stock market is probably more worried about inflation, adjusting p/e accordingly, than it is worrying about weaker profits. On the other hand, hey I am an economist and this is why no bet is certain, Fed needs growth and asset inflation. There is no rational reason for them to put the brakes on the economy.

Inflation, over time, will increasingly become a problem. All these past years of all the central banks pumping liquidity into the system! At some point, financial assets are swapped into physical goods and with a vengance. Its begun, and its only the beginning. Quite a spot Mr. Greenspan left for Mr. Bernanke. In the meantime, 50/50 for August and lets stop looking for the big slow down -- it is a long way off.