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December 2, 2007

Fed Watch: First Fed Speaker Comes Out Against Rate Cut

Tim Duy evaluates the chances of a Fed rate cut in light of recent price data and comments from St. Louis Fed president William Poole:

First Fed Speaker Comes Out Against Rate Cut, by Tim Duy: St. Louis Fed President William Poole became the first Fed official to speak in the wake of recent financial disruption. For those looking for a rate cut before the September meeting, his interview with Bloomberg was not particularly supportive:

'I don't see any impact as yet on the real economy or on the inflation rate,' he said in an interview in the bank's boardroom. 'Obviously, there could be an impact, but we have to rely on some real evidence.'

Barring a 'calamity,' there is no need to consider an emergency rate cut, Poole said.

'No one has called up and said the sky is falling,' Poole said today. 'As I talk to companies, their capital spending plans are intact.'

Moreover, those looking for a cut in September should note Poole’s warning:

Poole said he didn't regret that the Aug. 7 statement retained a bias against inflation. He also said that while consumer price gains are 'moving in the right direction,' the 'job is not done.'

Important comments as they came after the release of today’s CPI report for July. While the trend appears to be in the right direction, the Fed simply lacks conviction inflation will continue to head in their desired direction. Not really that surprising – although core CPI was up just 0.2%, after a downward rounding, note that the 3-month annualized rate stands at 2.5%, well above an acceptable rate.

As I noted earlier this week, the Fed is considerably more deliberate than market participants when it comes to changing policy. The flow of data so far is not supportive of a rate in September.  To be sure, retail sales data were not spectacular, but consumer weakness is expected by the Fed – they anticipate a rising savings rate. Industrial production was ahead of expectations, and, most importantly, the June trade figures are likely to push 2Q07 above 4%. Don’t ignore the potential for the external sector to support growth in the quarters ahead. Exports growth looks set to continue, while sagging consumption is likely to come at the expense of import growth – those flat screen TV’s are not made on these shores.

Felix Salmon has posted what I believe to be a misleading chart suggesting that the Fed changed policy in the past week. Thankfully William Polley provides some context, noting that the downward pull on the effective Fed Funds rate is being driven by few trades at extremely low rates.  Importantly, he notes that the high end of the trading range remains right where is should be. My interpretation of the low trades is that the New York Fed is erring on side of caution, not unreasonable given the current frenzied state of market participants.

I will quibble with this from Polley:

Remember also that this infusion of liquidity represents reserves, or base money. It doesn't get multiplied through the deposit process unless banks lend those reserves to create new deposits. Something tells me that's not going to be an enormous risk in this case. Intermediaries are more likely to be carrying some excess reserves at this point.

The reason this is not a risk is the seemingly forgotten fact that these are temporary operations – all with the exception of one 14-day operation last Thursday are overnight repos. The money goes in, the next morning it goes out and new money, if necessary, is put in. Financial reporters insist on ignoring the second part of a repo operation. And clearly banks will not lend out money they know they will only hold for 24 hours or less. 

Of course, the Fed does also change the size of its portfolio with permanent open market purchases. This would permanently change the amount of base money available for loans and the money creation process. The last such operation was on May 3 for $1.4 billion. I hope the NY Fed is not planning another permanent purchase anytime soon – who knows how it will be interpreted.

Bottom Line:  The path to a rate cut will not be as direct as appears to be priced into markets; the Fed will resist until they see hard data to justify a policy shift.

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