Saturday, January 27, 2007

Fed to hold a steady course at 5.25% for all of 2007 and probably into 2008

It has been amazing how dramatically the market has come around in the past few weeks to sharing my belief that Fed rate cuts are simply not in the cards any time soon. Not too long ago three cuts before the end of the year were considered likely. Now, there is zero expectation by the market for a cut in the first half and only a 62% expectation way out in December.

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, and probably into 2008.

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 10% decline is needed by March. If we don't see crude oil consistently below $50 and retail unleaded gasoline consistently 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.

From two weeks ago: 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.

Update: Both crude oil and gasoline have bounced up a bit (even as declines at the retail level may continue for gasoline for awhile longer), but this was likely a technical move rather than based on fundamentals. Crude is at $55.50 and wholesale gasoline is at a level equivalent to $2.08 to $2.13.

My latest thinking is that $60 may be the magic number for crude oil for the Fed in May even though $50 is what they would really like to see. If crude is $60 or higher in May, the Fed will have a high probability of a hike to 5.50%. If crude is below $50, the probability of a hike is very low. If crude is at $55, it will be a 50/50 coin flip. At $58, the Fed would seriously consider a hike. At $53, the Fed would likely hike only if there were some other significant factors, such as a strong resurgence in housing demand.

The point here is not $58 crude oil per se, but the fact that $58 crude oil means that either real demand is overly strong, or there is too much monetary liquidity in the financial system that inspires speculators to throw too much money around because it is relatively too cheap and the Fed will feel some pressure to "mop up" such excess liquidity.

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 (this coming Wednesday): 2% chance of a cut
  • March: 0% chance of a cut
  • May: 2% chance of a hike
  • June: 4% chance of a cut
  • August: 20% chance of a cut
  • September: 26% chance of a cut
  • October: 42% chance of a cut
  • December: 62% chance of a cut
  • January 2008: 76% chance a cut

I personally don't concur with these odds after September, 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 October. The market is predicting a cut at the December 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 (this coming Wednesday), 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 January 11, 2007 edition of the UBS As We See It - Market Viewpoint report, UBS Wealth Management Research continues to forecast a Fed funds rate of 4.00% by the end of 2007. That would be five quarter-point cuts. They also continue to forecast 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 October, 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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