Wednesday, October 31, 2007

FOMC Cuts 25bps...

... and they say they're done.

Or to be more precise, now that they've cut a total of 75bps, they've got a neutral bias with upside risks to inflation balancing downside risks to growth. So going forward rates are as likely to go up as down.

Here's the statement:
The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4-1/2 percent.

Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; Eric S. Rosengren; and Kevin M. Warsh. Voting against was Thomas M. Hoenig, who preferred no change in the federal funds rate at this meeting.
The problem I have with this statement is that it doesn't conform to what most members have said. There was clearly a very wide range of opinions going into this meeting, with Hoenig on the hawkish side and Mishkin on the dovish side, and everyone else scattered between. But unlike most meetings, the difference in preferred policy options between the hawks and the doves was a wide 50bps. That made it fairly easy to predict a 25 bp cut as a compromise, but it makes the interpretation of the statement a bit more complicated.

Why, for example, does the statement say the risks to inflation are roughly in balance with the downside risks to growth? Besides Hoenig, and maybe Plosser and Fisher, who believes that? Certainly not a majority on the FOMC. In late July, right before the mortgage meltdown, in his Humphrey Hawkins testimony, Bernanke forecasted real GDP growth in 2008 of 2.5% - 2.75%, and core PCE inflation of 1.75% - 2%. That's growth just barely at potential, and inflation within their comfort zone. Since then, every Fed speaker who's mentioned it has said the outlook for growth in 2008 has declined, downside risks have increased, and the outlook for inflation has moderated. So the consensus view of the FOMC is growth below potential in 2008 and inflation falling (Yellen, for example, has said this explicitly). That's not a scenario with balanced risks.

So how did we get this statement? It looks to me like the committee compromised by giving the moderates the rate cut, but giving the hawks the statement. The hawks are hoping the statement is tough enough to tie the FOMC's hands at the next meeting. But that's only going to happen if there's no bad news between now and then, and that isn't what's in the forecast...


Karl Smith said...

I think you are right in that the doves got the cut and the hawks got the statement.

Of course, I thought it should be played the exact opposite way, no cut and a statement that emphasized the downside risks to growth.

We may very well see threats to growth that justify another 25 bps in December.

What is the FED supposed to do then?

If they cut, then no matter what language they use, there will be a sense that their talk on inflation is not as serious as perhaps it could be.

My guess at this point is that a growing weakness and possibly bad number in Nov could force another cut, but it would be unfortunate.

Marc Shivers said...

Hi Karl,

I guess I don't see inflation as that much of a problem right now relative to the growth risks as you do. You can still make a good case that policy is still a bit on the restrictive side, even at 4.5%, unless you're very optimistic about productivity growth picking back up.

The more I think about it, the more it seems the debate should be framed around where the neutral rate is.

Everyone more-or-less agrees that the current rate of growth is healthy and inflation is moderate, so if we agree on where neutral is, the debate could narrow to whether you think policy should be slightly above or slightly below that.

My guess is neutral is about 4.25%, and by January we'll want to be slightly below that.

What do you think?