Wednesday, January 24, 2007

Some Berry Good Thoughts . . . . So What Does Trigger The Fed

In today's Bloomberg, John Berry writes that the Fed is going to do more of the same -- watch, wait, and note that the greater risk is inflation. Inflation is the risk because money is cheap and available and as long as credit can expand so too can the economy.

How easy is money? This was reported in this morning's Wall Street Journal:
The investing arms of Goldman Sachs Group Inc. and Morgan Stanley are quietly collaborating on a massive private-equity play for the oil-and-gas assets of utility company Dominion Resources Inc. -- a deal that could top out at $15 billion, people familiar with the matter said.
When $15 billion and play are in the same sentance, money and credit aren't being rationed.

Back to Berry.

He sets the stage by writing:

A few weeks ago, many financial analysts were predicting that slowing growth would prompt the Fed to adopt more neutral language at the Jan. 30-31 meeting in preparation for reducing the target in March or May.

That prediction was a major misreading of Fed thinking.

I should say so. But the street savants are often wrong but never in doubt. So where does Goldman, the erstwhile private equity player, stand? Again, from the Berry article:
On the other hand, economists at Goldman Sachs Group Inc. haven't abandoned their forecast of 75 basis points of rate reductions in 2007, beginning by midyear.
Perhaps their economists should have lunch with the private equity guys. Since investors risk the firm's capital, the proverbial money going where the mouth is, I side with the risk takers.

Here is the meat of the story, at least to me:

Their counterparts at Macroeconomic Advisers LLC, who don't expect any such slowing in job growth, said in their weekly forecast update on Jan. 19 that they ``expect the Federal Reserve to maintain the fed funds rate at 5.25 percent throughout 2007.'' . . . .

. . . . They went even further, adding: ``The next decision for the Fed will be whether to resume tightening or to remain on hold, given the economy's apparent resiliency and the upside inflation risks emanating from tight labor markets.''

That's not a decision that is going to be on the table next week, however.

A number of Fed officials have indicated in recent speeches that they are quite comfortable with the current 5.25 percent target . . . .

They become uncomfortable if the curve flattens enough such that the market prices in a tightening before the Fed does. This occurs if data begin to reveal what this blog has been saying -- too much money chasing too few opportunities. As long as the curve behaves, so too will the Fed.

In sum, the Fed now turns a bit from data dependancy to watching the watchers.


Tax Shelter said...

Are you saying the inverted yield curve and shrinking NIM, if persist, won't push the economy into recession?

Rational Experience said...

Yes. In the past, an inverted curve resulted from the Fed aggressively trying to get the funds rate high enough to stall the economy by outpacing the bear market in the coupon cure. The move was typically accompanied by credit rationing by banks. This time around, the Fed has merely raised rates to neutral, perhaps a bit higher. At these levels, banks continue to lend. The current nversion comes from a bull move in the coupon curve that reflects market expectations that the Fed has the reigns on growth to the extect that inflation risk is mitigated. In sum, it is different this time. No recession. Also, weak currency big budget deficit countries generally run inverted curves.

Tax Shelter said...

So the yield curve inverted because long term rates moved below neutral? Interesting. But how do we know which rate is neutral?

Do you think fine tuning works, or the Fed just got lucky this time?

Anonymous said...

Do you believe the fed will cut rates the middle of this year? If forcasted real GDP is 2.2 and inflation is 2.2 thoughout 2007 doesn't this mean nominal GDP would be 4.4% in 2007. This would mean the fed would be 85 bp above nominal GDP growth pretty restrictive right? I would appreciate any comments Thanks!!

Rational Experience said...

if the economy slows to that level and looks like it will stay there or move lower, then yes the Fed would ease. I do not, however, believe that will occur. By now it should be obvious, especially with no move tomorrow, that the economy is doing just fine. The bigger issue is credit growth and the availability of funds. On that basis money is not tight and the economy should reaccelerate. Therefore, there is no chance here that the Fed eases. It is more likely that they tighten.

Anonymous said...

Rational Experience, How many basis points below nominal gdp do you believe is a neutral federal funds rate 50,75,100? Do you look at y/y nominal gdp or a five year average to determine neutral? Do you ever look at a real inflation adjusted federal funds rate to determine neutral? Right now a fed funds of 5.25 and nominal gdp of 5.9 y/y would be 65bps spread. Do you think the fed has to become restrictive to bring down inflation? What creates loan officers to tighten credit standerds? a restrictive fed funds rate. And do you believe there is a lag time beteween interest rate hikes and economic growth, some say 18-24 months this would mean we won't see 5.25 for another year? I love you blog I'm very facinated with monatary policy and the fed, keep up the good work!! Thanks for your help!

Rational Experience said...

I think of neutral as a funds rate running around 50 to 75 basis points under y-o-y nominal gdp growth. growth is more volatile than funds so the spread is not going to be steady. you can chart out the spread from 96 to 98 and get a sense of what is neutral. as for the credit question, economies stop when the credit creation process stops. banks stop lending, meaning they are more credit aware, when they believe the level of rates are at a point where businesses will slow and, at the same time, the inverted curve gives them a better return on riskless cash. we aren't there yet. as for the time lag, 18 months is the mantra, but i think that is from a different time. when banks were the primary intermediary. these days, it is the capital markets, whose reactions are fairly quick.

Anonymous said...

Rational experience,
What do you think of ISM at 49.3 today. This means manufacturing is in a contraction state. This has been a good leading indicator of the overall economy historiclly.

Anonymous said...

Sure banks are still lending, but what about people not being able to pay those loans. With Sub-prime and Alt-A mortgage defaulting increasing and the housing market sitting not too well, How do you think we are going to do then?

Selene said...

Good for people to know.

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