Saturday, January 13, 2007

Fed to hold a steady course at 5.25% for all of 2007

This past week we saw a significant improvement in sentiment about the economic outlook for 2007.To be sure, there are still plenty of people in the doom and gloom crowd, but suddenly a noticeable percentage of people are now at least "guardedly" optimistic about the outlook for 2007.

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 all of 2007.

There will not be a recession this 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 5.50%. 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 below $50 and retail unleaded gasoline under $2.00 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.

Note: I am not suggesting that the Fed will "target" commodities prices such as crude oil and gasoline, but that the Fed will be noticing the degree to which elevated commodities prices are influencing the rest of the economy and pushing up even core prices. We did have good news on the inflation front in the past couple of months, but that was primarily the result of the decline of crude oil and gasoline prices off the summer spike, but crude oil and gasoline prices have risen since November.

Update: Crude oil has fallen to within striking distance of $50 and wholesale gasoline has similarly fallen to within striking distance of the equivalent of $2.00 retail, but both are now sitting in a technically oversold position, so they could pop back up a bit in the near-term even if they do eventually resume their decline.

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 yields 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.

Please note that current Fed policy at 5.25%, or even a hike to 5.50%, is not restrictive, but within the neutral range which is neither accommodative nor restrictive. All "normal" economic activities can be easily financed with Fed policy at this level. This does eliminate a lot of excessive speculative behavior, but won't crimp the average business or consumer.

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

  • January: 4% chance of a cut
  • March: 2% chance of a cut
  • May: 12% chance of a cut
  • June: 28% chance of a cut
  • August: 54% chance of a cut
  • December 2007: 100% chance of a cut and 18% chance of a second cut
  • January 2008: 100% chance a cut and 46% chance of a second cut

I personally don't concur with these odds after May, 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 May. The market is predicting a cut at the August FOMC meeting, but that is too far in the future for the market to give a reliable forecast.

My feeling is that if the housing retrenchment hasn't caused a Fed cut by the January FOMC meeting, it is unlikely that housing will be enough of a problem to cause a Fed cut for the rest of the year either.

I note that as of the December 20, 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 May, 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.

Why are so many smart people so confused about the future? It is simply the fact that the conservative thing for them to do is to assume that economic events such as housing booms always play out in the same pattern every single time. For a bureaucrat, that is always the safe approach. Alas, every economic episode has its own idiosyncratic pattern and the real issue is how to forecast the interactions between the many sectors and regions of the economy, and that is a really hard problem that is absolutely not amenable to the cookie-cutter application of historical patterns.

The current "herd mentality" on Wall Street is basically sending so many speculators and even investors off on a truly wild goose chase, after which Wall Street will quietly acknowledge its error ("the data changed in an unexpected manner") and then chase those same speculators and investors back in the opposite direction, making sure to collect transaction fees and spreads on both legs of the roundtrip "chase."

Note that the Weekly Leading Index of the Economic Cycle Research Institute is telling us that the economy will be holding together nicely for at least the next few months.

-- Jack Krupansky

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