Saturday, November 25, 2006

Fed to hold a steady course at 5.25% until at least 2008

For now, my overall assessment of Fed monetary policy remains unchanged:

My view is that the Fed will keep the Fed funds target rate paused at 5.25% for the rest of the year, and for all of 2007.

It is also my view that there will not be a recession next year, nor even enough of a growth slump to trigger a Fed rate cut.

I tentatively say "for now" because I am half-convinced that the Fed may in fact feel the need to make another hike in the Spring (March or May). To my way of thinking, it all depends on what happens with energy commodities. Prices of oil and gasoline futures are still quite elevated, albeit off their Summer peaks, and this constitutes an ongoing source of inflationary pressure that continues to propagate throughout the economy. If prices of energy commodities resume their decline, the Fed will be able to remain paused for all of 2007. But if energy commodities prices do not continue to fall, the Fed may have little choice but to hike to 5.50% in March or May. Another 20% decline is needed by March. If we don't see crude oil back down in the mid $40's and unleaded retail gasoline under $1.80 by April, expect a Fed hike to 5.50% at the May FOMC meeting. Based on economic fundamentals, we should see the prices of energy commodities come back down to Earth, but unfortunately there is simply so much free cash sloshing around seeking "some action" and a lot of speculators are simply unable to resist the urge to try to run commodities prices back up since "it worked before." My view is that there is a fairly good chance that prices of energy commodities will recede in the coming months, but it may be too soon to bet too heavily against the speculators. My finger is on the trigger, but for now I'll retain my belief that the Fed will remain paused for at least another year.

Although the moderation of the housing boom will indeed hold back the economy over the next couple of quarters, the Fed seems to agree with me that this is to be expected and not an indicator of a coming recession. A lot of people are desperately funneling money into bond funds in response to an expectation of well below-par economic growth, and this is depressing Treasury yeilds and causing an inverted yield curve, but this is ultimately indicating only below-par growth (e.g., 1% to 2.75% rather than 3+%) for the coming six months. Yes, there is a lot of anxiety, but anxiety itself is not a reliable indicator of a particular outcome.

As of Friday, Fed funds futures contracts indicate the following probabilities for changes in the Fed funds target rate at upcoming FOMC meetings:

  • December: 0% probability of a hike and a 2% chance of a cut
  • January: 6% chance of a cut
  • March: 36% chance of a cut
  • May: 78% chance of a cut
  • June: 100% chance of a cut and a 4% chance of a second cut
  • August: 100% chance of a cut and a 38% chance of a second cut
  • December 2007: 100% change of two cuts and 36% chance of a third cut

I personally don't concur with these odds, but that is how a lot of people are actually "betting." I would simply note that such betting can change on a moment's notice as economic and financial data, not to mention commentary and sentiment, unfolds and evolves. Like it or not, the economy proceeds more through Darwinian evolution than "intelligent design." The Fed (and Wall Street) can influence the evolution, of the economy, but not control it as if it were a clockwork machine. Predicting the precise or even general impact of any Fed action or inaction is quite literally a fool's errand. Further, the "betting" on any last Fed move is usually more of an insurance hedge than an outright bet, more of a "just in case I'm wrong" kind of "bet". Finally, studies have shown that Fed funds futures are not a very reliable indicator more than 45 days into the future.

What the Fed funds futures market tells us clearly is that the Fed is most likely to leave rates unchanged at least through March.

I also note that as of the November 10, 2006 edition of the UBS As We See It - Market Viewpoint report, UBS Wealth Management Research was forecasting a Fed funds rate of 4.00% by the end of 2007. That would be five quarter-point cuts. They are also forecasting 2% GDP growth for 2007. Obviously I do not concur, although I welcome their alternative perspective.

The bottom line here is that the Fed won't move through January, and any speculation about Fed moves further down the road are simply wild guesses based on contrived stories about a hypothetical future economy that happens to have a mind of its own.

-- Jack Krupansky

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