Tuesday, September 19, 2006

FOMC Report
September 20, 2006

Autumn Winds Cool Hawkish Monetary Policy Expectations

Martin McGuire

Inside the Fed’s Head:

It was particularly interesting to see Mr. Lacker vote against the decision to pause at the last FOMC meeting. There is some comfort to be drawn from the sense that there was a bit of a struggle at the last meeting. As easy as it is to follow a program (pattern), especially after 17 consecutive advances in the policy rate, we can understand how necessary it is to have a lively debate about the appropriateness of ending that program. This is why I had suggested before the meeting in August, that while I fully expected the Fed to pause, it was likely the market would not completely price out the possibility that the Fed might hike. That was the case when the Fed Funds futures priced in only an 84% chance of a pause the day before the August meeting.

Looking back now at their decision to pause in August, committee members are likely rather pleased with their choice. It is not only that economic data has continued to come in a bit softer, but somewhat surprisingly, inflation reports have begun to soften rather than deteriorate further. I had expected the Fed to be somewhat patient with respect to the eventual waning of inflationary pressures as long as their base case for slower economic growth continued to prove correct. Their resolve in this matter has not been tested. Indeed, even today’s softer PPI helps round out a decidedly more friendly inflation backdrop than feared by many Fed officials.

Those who had expected a one session pause to show Fed independence followed by an additional policy move (hike) at tomorrows meeting have vanished like a migratory bird after the chill of the first autumn winds. They have either migrated to a view that the Fed will resume rate hikes in October (or later), or to a position that the Fed will settle into a long period of stable rates, specifically at current levels.

I think we should expect to see further migratory activity following, to a lesser extent, the statement accompanying the rate decision tomorrow, but more extensively following the release of the minutes and the next Beige book. This migration will favor further expectations of a long stable rate environment. However, there will be a few who will venture toward acceptance that the Fed may become accommodative within the first quarter of 2007.

We can sympathize with those who expect a more protracted period of pause. Throughout this current Fed policy cycle, the transition time from one Fed policy directive to the next has been quite long relative prior cycles. It is therefore quite reasonable for market participants to want and even expect a long transition period once again.

However, this is the first time within the current cycle where the Fed has indicated they are ‘data-dependent’ in their evaluation of appropriate monetary policy. While we recognize that the Fed is charged with adopting a monetary policy which fosters low inflation, growth in accordance with potential and low long term interest rates, we further understand that these directives are not met without consideration to incoming data. That said, I would still characterize the Feds most recent ‘restrictive’ policy directive as having been ‘path-dependent’. In this I mean that data which did not easily jibe with policy intent was more readily recognized as noise. I think I stated it better in my last report when I offered the following:

‘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.’

Long gone is the time when the Fed was restrictive in staccato fashion. However, in the past, the Fed enjoyed some comfort in their ability in impact risk assumption by leaving some uncertainty with respect to likely policy path. This clearly has not been the case for today’s Fed.

Those who would look for the Fed to begin an on again, off again rate hike campaign will be disappointed. We must believe that given the incredible tail risk to a prospect for inflation becoming unglued, the decision to pause in August was made with a large amount of confidence that inflation as well as inflation expectations were well contained. Even Mr. Lacker who voted against the move to pause did so because; ‘he believed that further tightening was needed to bring inflation down more rapidly than would be the case if the policy rate were kept unchanged.’ This is to say that while inflation was expected to moderate, it was not expected to moderate rapidly enough for Mr. Lacker’s taste. Mr. Lacker will likely vote in favor of a pause at this meeting.

I have read, reread and reread once again the minutes from the August FOMC meeting and my accompanying notes. I cannot help but be impressed with the consistency in which a softening economic backdrop is appreciated by Fed officials. The staff forecast prepared for that meeting advised: ‘…that real GDP growth would slow in the second half of 2006 and 2007, and to a lower rate than had been anticipated in the prior forecast.’ In all instances where warnings were made about the risk to inflation, the message appeared almost tragically as an afterthought or a moniker rather than a true expression of concern.

Riding the Wave:

I have noticed that with respect to sentiment change in interest rates that change in expectations usually come in waves. The first wave is characterized by expectations for a less restrictive Fed policy stance based on the belief that the Fed had already hiked enough or possibly too much. In this case, the long end of the yield curve enjoys some bullish price action as the threat of long running inflation pressure largely recedes. Wave two comes when some measure of Fed accommodation is assumed necessary at some point in the future to prevent or soften the expected decline in economic activity associated with the prior firming policy directive. During this stage, all boats rise with the tide. More specifically, the yield curve largely shifts toward lower rates roughly equal across the curve. This happens because market participants are either unable or unwilling to price a more specific timing for easier monetary policy conditions.

In the final wave, market participants mark up the curve their expectations that the Fed will need to act at some not so distant time to thwart growing evidence of a softening economy and lack of inflationary threat. In this final wave, market participants rush up the time line to price in prospects for a more immediate easing of monetary policy. It is my belief that we are currently somewhere between the second and final wave of the shift in sentiment change toward an easier Fed policy stance.

Current Six Meeting Forecast for Fed Funds Target:

FOMC Date Funds Target Risk Assessment
September 20, 06’ 5.25% Bal-Slow Eco
October 24-25, 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
May 9, 07’ 4.50% Bal-Low Inflation

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