Fed to stay on course at 5.25% for all of 2007 and probably into 2008

Despite the ongoing chatter about the "possibility" of a recession by the end of the year, the hard-core analysis and conclusion remains the same...

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 May or June 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 May or June. 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 or June 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.

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.

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 to th extent that it causes higher core inflation in the real economy.

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., 2% 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. The odds of such a hike causing a recession are negligible.

With all the chatter about the debate over the "possibility" of a recession by the end of the year, people bet heavily on early Fed action. As of Friday, Fed funds futures contracts indicate the following probabilities for changes in the Fed funds target rate at upcoming FOMC meetings:

• March: 2% chance of a cut
• May: 6% chance of a cut (was 36% a week ago!)
• June: 32% chance of a cut
• August: 84% chance of a cut
• September: 100% chance of a cut and 4% chance of a second cut
• October: 100% chance of a cut and 36% chance of a second cut
• December: 100% chance of a cut and 78% chance of a second cut
• January 2008: 100% chance of two cuts and 4% chance of a third cut
• February 2008: 100% chance of a cut and 98% chance of a second cut

The better than expected monthly employment report on Friday was a surprise for many people and caused a dramatic scaling back of betting on earlier rate cuts.

The March meeting is well within the 45-day window of reliability for the fed funds futures to predict Fed action, so it is a virtual certainty that the Fed will not changes the fed funds target rate at the March FOMC meeting. It is too soon for fed funds futures to reliably predict rates for the May FOMC meeting, but they will be in another two to three weeks. A lot can and will transpire during that period of time to whipsaw the odds for a rate change at the May meeting. My belief is that the odds of a cut will completely evaporate and in fact turn into odds for a hike. Ditto for June and August. Stay tuned.

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 -- which is precisely what we saw this past week. 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 June. 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 since the housing retrenchment didn't cause a Fed cut at 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.

As of the January 25, 2007 edition of the UBS As We See It - Market Viewpoint report, UBS Wealth Management Research forecasts a Fed funds rate of 4.25% by the end of 2007. That would be four quarter-point cuts. They 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 June, 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." Expect to see a reversal of the trend of the past week within a month.

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

-- Jack Krupansky