Although the headline GDP number of an anemic 1.3% annualized real growth was quite dispiriting, the exaggerated inflation component of the GDP calculation (4.0%, while it is generally accepted that core inflation was about 2.2%) suggests that we would do better by focusing on the nominal GDP growth rate of a healthy 5.3%. In fact, the odds of Fed rate cuts declined as a result of the GDP report (from 94% to 90% for a quarter-point cut in December.) The odds of a Fed rate cut in September are only 40%.
With mixed signals on both the inflation and economy growth fronts, the Fed will most likely decide to wait yet another monthly cycle before judging that inflation is either truly under control, or truly under poor control, and whether the economy is simply stumbling out of a soft patch and on the verge of accelerating or falling deeper into a slump. We need to see more than a little consistency in the signals before judging the degree of stability.
And with the economy being a little weaker than desired over the past few months, the Fed is likely to want to see some clear evidence that the recent "soft patch" is each receding or deepening before making further judgments about the economic outlook for the rest of the year.
Personally, I would suggest that the recent surge in speculation in commodities, including oil, gasoline, and metals is a dual indication of inflationary pressure and a huge excess of money or so-called liquidity, both of which together suggest that the Fed is likely to have to seriously consider another hike in the June or August timeframe.
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 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 a lot healthier than the 1.3% Q1 GDP growth rate "estimate" suggests.
I tentatively say "for now" because I remain half-convinced that the Fed may in fact feel the need to make another hike in June or August 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 June or August. If we don't see crude oil consistently below $50 and retail unleaded gasoline consistently under $2.00 by June, expect a Fed hike to 5.50% at the June or August 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 a hike is unlikely at the May meeting (less than 1 in 3 odds), but almost likely at the June meeting (45% chance).
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 way up at $66.46, 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 $2.3613 last week indicates an equilibrium retail level of $2.96 to $3.01, 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 May even though $50 is what they would really like to see. If crude is $60 or higher in June, the Fed will have a high probability of a hike to 5.50% in June or August. 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 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.
As of Friday, Fed funds futures contracts indicate the following probabilities for changes in the Fed funds target rate at upcoming FOMC meetings:
- May 9, 2007: 0% chance of a cut -- no chance
- June 27/28, 2007: 8% chance of a cut -- effectively zero chance
- August 7, 2007: 28% chance of a cut -- people are confused and uncertain, but not betting on a cut
- September 18, 2007: 40% chance of a cut -- people are confused and uncertain
- October 30/31, 2007: 64% chance of a cut -- almost effectively 100% chance, but still a fair amount of confusion and uncertainty
- December 11, 2007: 100% chance of a cut and 6% chance of a second cut
- January 2008: 100% chance of a cut and 50% chance of a second cut
- March 2008: 100% chance of a cut and 88% chance of a second cut
- May 2008: 100% chance of a two cuts and 10% chance of a third cut
The May meeting is now 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 May FOMC meeting. It is too soon for fed funds futures to reliably predict rates for the June FOMC meeting. A lot can and will transpire during the run-up to the May and June meetings to whipsaw the odds for a rate change at those meetings. My belief is that the odds of a cut will completely evaporate and in fact turn into odds for a hike in June. Ditto for August and September. Stay tuned.
I personally don't concur with these odds after June, 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." 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 is most likely to leave rates unchanged at least through September. The market is predicting a cut at the October 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 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 April 5, 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 are also forecasting a Fed funds rate of 3.75% by the end of 2008. They continue to forecast 2% GDP growth for 2007. Obviously I do not concur, although I welcome their alternative perspective.
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 through September, 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