Why the Fed is Right and the Market Wrong

There is an epic struggle going on between the Federal Reserve and the markets. The Federal Reserve has been very clear of its views. Growth will pick up later this year as the main headwinds fade. Price pressures, while elavated, will likely moderate. It sees the main risk to this benign scenario is that inflation does not ease.

The market has been just as consistent with its views. During much of the tightening phase that lasted from June 2004 until June 2006, the market under-estimated both the duration and magnitude of the rate hikes. And in the year since The Pause, the market has repeatedly priced in a cut for the following quarter only to push it further out in time.

The market has never taken seriously the Fed’s risk assessment that sees inflation as the “predominant” concern. Instead, judging from news wire accounts, many economists and market participants are concerned about growth and in particular the knock-on effects of the collapse in the housing market. They appear particularly concerned that this may be finally the blow forces the US consumer to retrench. In addition, with corporate earnings growth slowing, business investment is unlikely to offer much support either. Some economists have been warning for a year that the US was headed for a recession.

Other observers take the arugment further. They intimate that the problem is one of over-reach. The US consumer and government lives beyond it means. The savings rate is abysmal. Some people who could not really afford homes managed to purchase them. The US trade deficit remains large despite the US slowdown in relative and absolute terms, which in the past has often coincided with improvement in the external balance. Indeed, the March trade data suggests that the drag on the economy from net exports in Q1 was substanitally greater than the government’s preliminary estimate indicated and will likely drag Q1 GDP down below 1% when it is revised.

The problem seems to reflect three confusions. It confuses cyclical and structural arguments. It confuses the rearview mirror with the windshield and it confuses what some economists think the Fed ought to do, with what the Fed is likely to do.

Although it is true that the Fed historically has been sensitive to systemic risks, for the most part it seems monetary policy is aimed at extending the business cycle, seeking as its dual mandate demands, full employment and price stability. Monetary policy, that is influencing the price and quantity of money cannot really address many of the structural issues that worry economists.

The Fed is nothing if not forward looking. The Federal Reserve’s statement recognized that the economy slowed in Q1, but clearly that is neither necessary nor sufficient to change policy here in the middle of Q2 Indeed this acknowledgement did not alter the Fed’s view that what ails the economy is likely to prove transitory. Judging from consensus growth forecasts for the remainder of the year, many economists seem to broadly agree with this assessment.

And for good reason. The very things that were behind the sub-par performance and the likely downward revision to Q1 GDP are likely setting the table for stronger growth going forward. There continue to be signs that residential construction is stabilizing and is unlikely to take 1 percentage point off Q2 GDP as it did in the first quarter. Moreover, non-residential construction is roughly the same size as residential construction as a fraction of GDP and appears to be offsetting part of the weakness in the housing market.

Inventories also seemed to be an important drag on Q1 GDP, but now much leaner, the rebuilding of inventories is likely to contribute to GDP in the coming months. The trade deficit shaved Q1 growth, but may contribute positively to growth here in Q2. The decline in real goods exports, the first drop since Q4 02 looks like an anomaly. Global demand remains strong, the dollar is competitive and the forward-looking ISM reports showed increased exports. Also there was a plunge in aircraft exports that also seem unlikely to be repeated.

In addition to the positive signals being generated by the ISM data, April tax receipts have been strong and this would seem to suggest good economic activity. Weekly jobless claims suggest a rebound in jobs this month after the soft April figures. Money supply (M2) continues to expand faster than nominal growth, which is thought indicate stimulative monetary conditions. The rising stock market also, fueled at least in part by strong M&A activity, private equity deals, and corporate buy-backs (done often with borrowed funds) also speaks to an accommodative monetary policy.

The inflation side of the equation is more difficult. With growth well below trend, one might have expected price pressures to ease, but they haven’t in any meaningful sense. The Federal Reserve was given their dual-mandate from Congress, but they defined for themselves the metrics. Fed officials have identified the core personal expenditure price index as the preferred measure and have identified 1-2% as their comfort band. This is different than say the Bank of England, which recently had to explain why consumer prices (headline) overshot the 2% rate by 100 bp, which Her Majesty’s Treasury provided to it. For the better part of three-years now, the Fed’s measure has not been in their comfort zone.

If the Fed capitulated and delivered the rate cut that the doom-and-gloom camp and the bond salesmen have been calling for, it would likely be criticized for not being sufficient resolute in fighting inflation. In the short-run and long-run, given the US debtor status and leveraged economy, the risk for international investors is that the US tries to inflate its way out of its problems.

Since Federal Reserve Chairman Bernanke’s first month in office, his anti-inflation credentials have been challenged. Ironically much of his academic work is devoted to studying inflation and policy. Some of the criticism of Bernanke reflects procedural issues. His desire for a rule-based approach contrasts with Greenspan’s ad-hocery. His more collegiate style is thought to contrast with Greenspan’s authoritative approach, where it has been said that sometimes the Fed’s statement would be written prior to the FOMC meeting for example. But these are stylistic issues not substantive. On substantive grounds, few of the Fed’s critics acknowledge that Bernanke’s first year was much smoother than the Maestro’s.

The Federal Reserve is not asleep at the switch. It sets policy according to what it expects to be the future trajectory of the economy. It believes that maintaining price stability is an important aspect of its desire to promote strong growth and does not represent conflicting policy objectives. The more that the market questions the Fed’s credibility, the more Bernanke and Co. need to take actions that contribute to its anti-inflation credentials. To ask what Greenspan would do, misses the point. Bernanke is not Greenspan. Hallelujah
Why the Fed is Right and the Market Wrong Why the Fed is Right and the Market Wrong Reviewed by magonomics on May 07, 2007 Rating: 5
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