Monday, August 21, 2006

A Pause in August means a Pause in September

FOMC Report
August 8, 2006

A Pause in August means
a Pause in September

Martin McGuire

Inside the Fed’s Head:

Fed rhetoric over the period following the June FOMC meeting has shown a heightened concern for the prospects of deterioration in inflation expectations. Despite these often spoken concerns, the market has priced roughly an 84% chance of a pause at the August FOMC meeting as of settlement August 7, 2006.

It might be taken as a market miss-step that collectively it is not willing to interpret the Feds warnings as an indication that the Fed is intent on raising the Fed Funds rate to 5.5% (25 basis points) at the August FOMC meeting. Rather, the Fed has indicated an interest in allowing forthcoming data to guide forecasting of future economic and monetary conditions which will then determine the subsequent path of Federal Reserve policy.

Of those who expect a pause in the series of 17 consecutive 25 basis point rate hikes, there are many who envision a protracted period where the Fed Funds target is left unchanged. This would be consistent with the slowly evolving policy adjustments over the past three years. During this period the Fed subscribed to being ‘patient’ and advanced the notion that an accommodative monetary posture could last a ‘considerable period’. This evolved to ‘measured pace’ of accommodation removal which had only very recently been abandoned.

There should be a natural tendency for market participants to look for another protracted period of non-volatile adjustment to what some will assume is a neutral Fed. However, under a ‘data dependent’ policy regime, the Fed does not have the luxury of classifying discordant data as noise. It was able to do this as it looked past the scattered non-compliant incoming data to the goal of reaching ‘neutral Fed Funds’. However as the Fed has arguably now found the ‘neutral’ Fed Funds rate, it can no longer treat casually data which contradicts to its own expectations.

One Pause Deserves Another:

While I would suggest that a pause in August will heighten the chance of a further pause at the September FOMC meeting, I would not expect a condition of a stationary target Fed Funds to prevail indefinitely. As ‘neutral Fed Funds’ is a moving and ever evolving condition, so too will become the ‘target’ Fed Funds rate.

A pause in August is expected to be followed by a further pause in September because the amount of data available for analysis between the August and September meetings will be insufficient to confirm (or rebuke) the Feds expectation that the cooling economy is reigning in the inflationary pressure. While there will be a number of inflation reports over this period, there will only be one employment report. So unless the inflation reports are egregious, we should expect that a pause in August will mean a further pause in September.

A ‘soft landing’ is certainly a possibility here as housing may slow just enough to calm consumer appetites and business concerns spend just enough to keep the good times rolling. This may then allow for a small increase in the slack in resource utilization that will bring inflationary tendencies under control. As attractive as this story line goes, I get a better kick out of reading fairy tales to my four year old.

Line up on one side or the other as to whether the Fed has already overshot or that a pause here is one big step closer to a run-away inflation situation. Either of these two camps has a better chance of being proven correct than a ‘soft landing’. The economy will either suffer under the weight of the removal of risk assumption or the slow and steady Fed will be shown as being too little too late to control inflation.

Should the Fed pause as I believe, it is most likely that Fed officials have agreed that the risk appears quite weighted toward a slower economy and decelerating inflationary conditions. Because the tail risk for run-away inflation is too great to consider lightly, Fed officials will need to be quite convinced that the economy will continue to cool. They will also need to be quite certain that the recent swelling in inflation reports is a temporary condition that will ease with growing slack in resource utilization expected.

This is why I would read a pause as a large step toward the next change in target Fed Funds as being an ease. I am not implying that if the Fed pauses we need not pay any attention to economic and monetary developments. Rather, I am suggesting that Fed officials must be quite certain that inflation will be contained if they choose to pause. Therefore, economic and/or monetary developments will need to be decidedly outside their comfort zone for at least a two meeting period before Fed officials admit defeat (success).

For quite some time my basis for Fed projections has been that the visibility provided by the Feds transparency in the prior period of ‘path-dependent’ policy directive was sufficient to prompt higher levels of risk assumption than would normally have been the case in a less predictable, restrictive policy directive. The removal of visibility resulting from the recent change to a ‘data-dependent’ policy directive (irrespective of any level of transparency) should prompt some unwind of excessive risk exposure that was enjoyed during the period of greater visibility.

Finally, if I am incorrect in my expectations that an easier monetary policy directive should follow a pause, it will be because of a change in the reaction function of the most recent restrictive policy directive (‘path-dependent’). It is possible that the pace of monetary policy firming just concluded was so measured and understood that it thwarted the usual liquidity draining mechanism.

The impact from a like amount of policy restriction (from 1 to 5.25% Fed Funds) under the ‘old school’, less transparent Fed would arguably have had a much greater. The Fed may decide at some future date that the new and improved higher level of Fed transparency, especially along a path-dependent restrictive policy directive, has negative policy implications. Specifically, that risk may be that it prompts market participants, main street store front owners and consumers alike to expand rather than contract their risk appetite in the face of higher target Fed Fund rate.

Bottom Line:

It is easier for the Fed to pause at this juncture. The market is giving their blessing by pricing in a high probability of a pause. Should the Fed decide to raise rates because of lasting concerns for rising inflation expectations, the market will undoubtedly exaggerate the Feds concerns and price in a decidedly more restrictive policy intent. This would certainly remove any reasonable chance of a softer landing.

Mr. Bernanke has indicated in his research that he views Fed transparency as being successful when the first few Fed Fund Future contracts move very little following the FOMC meetings. Mr. Bernanke is clearly a big proponent of Fed transparency. It is only reasonable then that as the market has priced in an 84% chance of a pause, the Fed recognizes that this is how the market has interpreted the Feds intention based on Fed communications and economic and monetary data.

Certainly the statement accompanying a pause will need to recognize the importance of inflation vigilance. However, these concerns will likely fall on deaf ears as market participants overwhelmingly concentrates on the pause.

Current Six Meeting Forecast for Fed Funds Target:

FOMC Date Funds Target Risk Assessment
August 8, 06’ 5.25% Balanced
September 20, 06’ 5.25% Bal-Slow Eco
November 01, 06’ 5.25% Bal-Slow Eco
December 12, 06’ 5.25% Bal-Slow Eco
January 30-31, 07’ 5.00% Slow Eco-Low Infla
March 20-21, 07’ 4.75% Slow Eco-Low Infla

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