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December 3, 2007

Fed Watch: Waiting for the Inevitable

Tim Duy continues with his analysis of the likelihood that the Fed will cut its target interest rate:

Waiting for the Inevitable, by Tim Duy: As I noted yesterday, the Fed let the genie out of the bottle last week; rather than dissipating expectations for a rate cut, the statement had the exact opposite effect. Analyst after analyst is lining up to predict not just a cut, but the beginning of a rate cutting cycle. It is tough to see how they can avoid delivering at this point:

The Fed does not want to cut rates; they are searching for a middle ground between maintaining their inflation concerns while promoting stability in the financial markets. Consequently, I do not believe the Fed’s discount rate cut was intended by policymakers to be simply a symbolic move. I think the Wall Street Journal summarizes the Fed’s intentions quite succinctly with:

In essence, the Fed is following advice that British journalist Walter Bagehot offered in his 1873 book, "Lombard Street," a copy of which Mr. Bernanke kept on a shelf when he was Princeton professor. In times of "internal discredit" -- when uncertainty leads private players to pull back -- the prescription to the central bank is: Lend freely.

Unfortunately, an effort to avoid cutting the fed funds rate at this point is hampered by at least four factors:

1. The credibility on the “subprime is contained” story is simply shot. That calls into question their judgment on the ultimate economic impact of the subprime turmoil. Now we need the data to confirm the Fed’s view, rather than giving the Fed the benefit of the doubt until that data arrives. The confirming data is weeks if not months away; market participants will read positive data as old news, while focusing on the weak data.

2. The failure of the emergency statement to mention anything about inflation leaves little room to suddenly turn around and scream “inflation” even if inflation holds above their comfort level. That credibility thing again.

3. The market has fully and completely embraced the rate cut story – note Monday’s amazing surge in short dated T-bills. If the Fed thought they were having a crisis of confidence last week, just see what happens if they attempt to verbally reverse the new expectations.

4. Cutting the discount rate may have very little impact, regardless of the Fed’s intentions. Not only is it widely viewed as just symbolic (regardless of the Fed’s intentions), it does not get to the heart of the matter, the question of the fundamental value of subprime-based assets. Moreover, commentators have noted that given funding alternatives, banks have little incentive to pay the penalty rate, and some believe that the banks that do go to the discount window are simply doing it as a show of support. In essence, the Fed may have nullified the effectiveness of the discount rate when it was changed to a penalty rate – the jury is still out.

As far as what all this means for the economy, I already thought the next few months would look weak, and am much more interested in next year. Quick thoughts on the outlook:  Note first the steepness of the yield curve given expectations of easing. About as steep as one can expect given the starting point of low 10 year rates to begin with, and a pretty good signal that the economy will be chugging along quite nicely next year (see also Jim Hamilton on the corporate-Treasury spread). Second, notice that a policy shift now means the Fed would initiate a rate cut cycle on the backside of an inventory correction:

Duy822

The closest example of such a move was the emergency cuts in the fall of 1998, when, arguably, the Fed did not have the data in hand to show the economy was convincingly on the backside of the inventory correction. You know the story after that. This time, the Fed will be cutting well in advance of any new correction that might be forming.

Finally, thinking into 2008, three more points strike me:

1. The Chinese government will pull out all of the stops to keep the economy running at full steam through the Olympics. Too much national pride is at stake. Don’t underestimate the power of central planners to dictate short run activity.

2. Assuming the Fed does ease, they will be slow to reverse the easing. We have been through this before in 1999.And next year is an election, with the incumbent party looking, shall we say, weakened…not to question Fed independence, but after seven years of this administration, my innocence is lost.

3. There is a real chance that productivity is pulling back from the accelerated rates of the late 1990s.At the same time, labor force participation is pretty much topped out for secular reasons.

If you buy this story (it is not the only story), then you can do the math on the inflation implications for 2009. You can see why the Fed just might want to keep policy steady – there is a distribution of possible outcomes for the US economy, and the bearish story is not the only one.

Tough times for a Fed watcher – knowing the Fed wants to hold steady, but seeing the box they made closing in around them. It is difficult to see what combination of data and events will allow the Fed to hold steady in the months ahead at this point. The best chance for the Fed to avoid a rate cut (a cut they don’t want) is that both the financial markets remain calm and the August jobs report is very strong.

[Update: See also Fed Rate Cuts Are a Possibility, Not a Certainty, by John M. Berry]

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