Saturday, June 30, 2007

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

[Gentle reminder: I may suspend this weekly post in the near future, but I haven't decided for sure yet.]

Most people expect the Fed to be "on hold" for the rest of 2007 and at least Q1 of 2008, but more than a few are once again expecting a cut in Q2 of 2008. On the other hand, that may be more of an insurance hedge rather than an outright bet. Besides, Q2 of 2008 is simply too far in the future for anybody to have high confidence about the economic and inflation outlook.

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

My view is that the Fed will keep the Fed funds target rate paused at 5.25% for all of 2007, and probably well into 2008.

There will not be a recession this year, nor even enough of a growth slump to trigger a Fed rate cut.

The Fed will not cut rates in response to the concern about subprime mortgages.

The Fed will not worry about the health of the economy since it is MUCH healthier than the 0.7% Q1 "real" GDP growth rate "estimate" suggests.

I would suggest that there is a 1 in 3 chance that the Fed will hike rates by a quarter-point at either the August or the September FOMC meeting.

I tentatively say "for now" because I remain half-convinced that the Fed may in fact feel the need to make another hike in August or September 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 August or September. If we don't see crude oil consistently below $50 and retail unleaded gasoline consistently under $2.00 by July, expect a Fed hike to 5.50% at the August or September 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.

My current feeling is that the 0.7% Q1 GDP number has frightened so many people (and emboldened so many bears and cynics) that the Fed will likely simply wait until the Q2 GDP number "prints" in late July before seriously considering a rate hike in August. Another line of thought suggests that after the apparently weak Q1, the Fed will want to see two full quarters (Q2 and Q3) of reasonably robust economic growth before risking another hike.

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 over time. The price of crude oil remains up at $70.68 (up sharply from $68.00 two weeks ago), which has to concern the Fed. The Fed is usally quite tolerant of short-term energy and food price spikes because they tend to quickly recede, but oil and gasoline and other energy prices have remained persistently high for a prolonged period of time, which results in upwards pressure on core, non-energy prices. Wholesale gasoline remains well above $2, and at $2.2942 last week (up sharply from $2.2601 two weeks ago) indicates an equilibrium retail level of $2.89 to $2.94, which is too far above $2 to give the Fed any comfort that inflationary pressures are "subdued."

My latest thinking is that $60 may be the magic number for crude oil for the Fed in June even though $50 is what they would really like to see. If crude is $60 or higher in July, the Fed will have a higher probability of a hike to 5.50% in August or September. 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 the 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 have been desperately funneling money into bond funds in response to an expectation of well below-par economic growth, and this has depressed Treasury yields and caused an inverted yield curve, but this is ultimately indicating only below-par growth (e.g., 2.25% to 3.25% 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.

Note: There were reports this past week that Kansas City Federal Reserve Bank President Thomas Hoenig publicly characterized the federal funds rate at 5.25% as "in my judgment that is modestly restrictive, not severely, but modestly so." To my knowledge, he is the only and first Fed official to chacterize current monetary policy as "restrictive." It is worth noting that he felt the need to insert the caveat "in my judgment", suggesting that he does in fact recognize that it is his opinion and not offical Fed policy. I will keep my ears open for any such statements from other Fed officials. Some media reports quoted Hoenig as saying "moderately restrictive", and since the text of his remarks were not offficially posted or reported in full transcript form, we don't know for sure what he actually said or the actual immediate context. We should not take the public statements of any Fed official lightly, but sometimes individual Fed officials might choose to stray from the official policy, either by their own design or inadvertently. President Hoenig was speaking to a group of local bankers and businessmen in Cody, Wyoming, so he may simply have chosen more casual language that they would be more likely to understand than the more arcane "Fedspeak" that normally requires even motivated Fed followers to be very careful when they dissect it. Unless we hear at least two more Fed officials speak in the same terms of monetary policy as being "restrictive" within the next couple of weeks, it may be safe to write off Hoenig's characterization as being a one-time abberation to normal Fed communication about monetary policy and that Fed monetary policy does in deed remain in a "neutral range" rather than being "restrictive", let alone "moderately restrictive."

According to a report from Bloomberg,  Peter Hooper, chief economist at Deutsche Bank Securities characterized the Fed position by saying that "Their general feeling is at 5 1/4 percent, the fed funds rate is probably slightly restrictive." That is his characterization, his opinion, but that is not a position that has been officially or generally espoused by the Fed. Besides, "slightly restrictive" is clearly not "moderately restrictive."

Update: There has been no further suggestion that Fed policy is "restrictive", so I think it is safe to conclude that the overall view of the Fed is that their intention is that policy is in the "neutral range" and not "restrictive."

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

  • August 7, 2007: 4% chance of a cut -- slam dunk for no change
  • September 18, 2007: 8% chance of a cut
  • October 30/31, 2007: 16% chance of a cut
  • December 11, 2007: 32% chance of a cut
  • January 2008: 42% chance of a cut
  • March 2008: 58% chance of a cut -- a bit better than a coin flip chance that a cut is likely
  • May 2008: 70% chance of a cut -- a cut is likely
  • June 2008: 76% chance of a cut -- a cut is likely

The August FOMC meeting is now within the 45-day window of reliability for fed funds futures to predict Fed action, so it is reasonably certaint that the Fed will not change the fed funds target rate at the August FOMC meeting. It is too soon for fed funds futures to reliably predict rates for the September or October FOMC meetings. A lot can and will transpire during the run-up to the August and September meetings to whipsaw the odds for a rate change at those meetings. My belief is that we will continue to see rising odds for a hike in August or September or the Fall.

I would 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." Emergent phenomena and evolution are the norms for the economy. 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 will most likely leave rates unchanged for the rest of the year. Futures suggest a rate cut in March or April, but that is too far in the future for the market to give a reliable forecast.

My feeling is that since the housing retrenchment and so-called subprime "crisis" didn't cause a Fed cut at the January (or March) FOMC meeting, it is unlikely that housing or the so-called subprime "crisis" will be enough of a problem to cause a Fed cut for the rest of the year either.

As of the June 28, 2007 edition of the UBS As We See It - Market Viewpoint report, UBS Wealth Management Research dramatically revised its forecast and now calls for a Fed funds rate of 5.00% by the end of 2007 (versus a forecast of 4.50% just two weeks ago) and a total of three quarter-point cuts rather than six. They tell us that "The healthier US economy prompts us to delay the first Fed cut to December from September 2007 and to expect less total easing of 75 basis points instead of 150." They now forecast a Fed funds rate of 4.50% by the end of 2008 compared to their forecast of 3.75% just two weeks ago. They continue to forecast 2% GDP growth for 2007. Obviously I do not concur, although I welcome their alternative perspective. It sounds to me that their commitment to their "call" is rapidly crumbling and that they themselves are on the verge of admitting that they are clueless.

Why would the UBS outlook be so far off from my own view or even from the pessimistic market view? The wide divergence of these views doesn't make sense, right? Well, that's true if one were considering only economic fundamentals, but we do need to take into account that UBS has a customer base that they want to preserve and that the "research" document I referenced is really marketing literature, most likely designed to make the existing UBS customer base feel that UBS is "in touch" with their customers and their "needs." That is par for the course with the big financial firms. Step 1 is to understand the hopes and fears and anxieties of your customers and step 2 is to directly tap into those hopes and fears and anxieties. Right now, a lot of people hear so many desperate and gloomy stories in the media and internalize that desperation and gloom, and the result is that firms like UBS have no choice but to send out a message of "we understand and share your fears and anxieties." Better to be wrong and keep your customer base than be right and lose your customers. The bottom line is that individual investors cannot look to the research and economic outlooks peddled by Wall Street for a balanced accurate view of how the conomy and businesses will likely unfold in the coming months or year or over any period of time.

The bottom line here is that the Fed won't move over the rest of the year or even the coming twelve months, 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.

The Weekly Leading Index of the Economic Cycle Research Institute is telling us, according to Lakshman Achuthan, managing director at ECRI, that "With WLI growth at its highest reading in over three years, U.S. economic growth is bound to pick up in the months ahead."

Maybe I really should go on a hiatus for this Fed post series since the markets and most Wall Street "professionals" have finally actually come around to my position after these many long months. Maybe I'll put this Fed post series into hibernation until I can sense that I have something different to say than what Wall Street and the fed funds futures are now telling us. It would appear that my work here is done. There is still some mopping up to do and plenty of opportunity for backsliding by Wall Street "professionals," so maybe I should say "I'll be back."

Update: The backsliding of the market over the past two weeks to a renewed expectation for a single cut in Q2 of 2008 demanded this update, but my hope is that I won't need to do another update until we see some significant change in the economic picture in July or August.

-- Jack Krupansky

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