Sunday, November 11, 2007

Market Stability vs Inflation Expectations

Ever since the Fed officially moved to neutral on Oct 31st, there have been renewed fears that the Fed will allow financial markets to deteriorate rather than cut rates and risk higher inflation.

This trade-off is particularly relevant now, because year-over-year headline CPI is expected to rise over the next several months. Take a look at the graph below. The grey bars are the historical year-over-year CPI rates. The little red bars are the monthly rates. The blue bars are what YoY CPI will be over the next several months if the new monthly CPI numbers come out at a well-contained 2% annualized rate (or 17bps/month). Notice that the YoY rate will trend higher over the next few months, even if the incoming monthly CPI number are low. The actual CPI numbers are likely to be even higher, since the rise in oil prices makes the assumed 2% annualized monthly CPI unreasonably low.

So what should the Fed's immediate focus be: Financial stability or headline inflation risks?

Bill Poole, in a speech last week, came down on the side of market stability:

Concerns that the [Oct 1987] stock market crash might spread to the economy more generally and affect economic growth prompted the FOMC to reduce its target for the federal funds rate by 50 basis points on Nov. 4, 1987. The FOMC cut the target fed funds rate despite the fact that inflation was running at an unacceptably high rate of over 4 percent. The FOMC reduced the target by an additional 30 basis points by Feb. 11, 1988. Once the crisis had passed, the FOMC began raising the target fed funds rate. I have emphasized that the willingness of market participants to take risks is essential to the healing process that restores normal trading in risky assets. When the Fed cuts its target for the federal funds rate, market participants know that the FOMC’s decision at its next meeting will be either to leave the rate unchanged or to cut further. Barring unusual circumstances, the FOMC would not consider a rate increase just after cutting its fed funds rate target. This approach to policy is appropriate when market conditions are fragile because market participants must be confident that they can take positions without the risk that the Fed might raise rates, which would reduce asset values, in the near term. Investors can then concentrate on determining the fundamental value of risky assets and can work on deals to buy such assets from holders forced to sell by their own impaired liquidity and capital positions. As investors accumulate profits from these trades, others are attracted and normal market functioning resumes.
So, according to Poole, the goal of rate cuts during times of market turmoil is to restore confidence sufficiently so that investors are again willing to hold riskier assets. That's problematic for Fed members who don't want to cut rates at the Dec 11th meeting, since markets are expecting a 25bp cut. If they don't cut, the level of risk aversion in the markets will increase, probably significantly. Kevin Warsh, nevertheless, took a more hawkish tone in his speech last week:
There are also important reasons to be concerned about the outlook for inflation. Although recent readings on core inflation have been favorable, prices of crude oil and other commodities have increased. These changes most likely will put upward pressure on overall inflation in the short run. Moreover, the decline in the foreign exchange value of the dollar could lead to higher prices for imported goods. If these same forces cause inflation expectations to become less reliably anchored, then inflation could increase in the longer run as well.
If the Fed could convince market participants of the rationale for focusing on core measures of inflation, they wouldn't have to face this kind of short-term trade-off.  Core PCE inflation is well-known to be a better predictor of future inflation than headline CPI is. This is not even remotely controversial among professional economists. The graph below shows past YoY core PCE inflation plus what the numbers will likely look like in the near future if the annualized monthly rate stays near 1.5%. Clearly there's no imminent inflation problem.

The problem the Fed has is with inflation expectations. Expectations of future inflation can be self-fulfilling and are a very good predictor of future inflation. So if people are going to look at the high upcoming headline CPI prints and decide that inflation is getting out of control, the Fed will be boxed in. They'll have little choice but to raise rates, which would throw lots of people out of work until inflation expectations come back down again. The irony is that core inflation is telling us (reliably) that there isn't an inflation problem; it's only the potential for inflation expectations to get out of hand that's creating the problem. That's why I think it's irresponsible of commentators like Barry Ritholtz to encourage people to focus on headline inflation, and why Mishkin and other Fed speakers need to continue focusing on a communication strategy to break the imaginary connection between non-core inflation and expectations for future inflation.

Tuesday, November 6, 2007

Mishkin Says He Really Is Neutral...

Governor Mishkin gave a surprisingly hawkish speech yesterday on "Financial Instability and Monetary Policy."

Mishkin has been the most vocal advocate on the FOMC for significant preemtive rate cuts. He's been arguing that financial market instability has the potential to significantly harm real economic growth and, if this were to happen while financial markets were still not functioning properly, that slowdown could spiral into a deep recession that would be difficult to reverse once it took hold. He therefore advocated aggressive rate cuts in advance of any evidence of a growth slowdown. That argument has gotten the FOMC to cut by 75 bps, even though many members sounded reluctant to cut preemptively prior to the Sept 18th meeting.

In the FOMC statement after the Oct 31st meeting, the Fed sounded like they were done cutting rates preemptively, saying that growth risks were now balanced with inflation concerns. But was this a message that everyone on the FOMC really believed, or was it a compromise that was required to convinced some of the more hawkish members to go along with the 25bp cut? I had guessed the later, given how vocal some members had been about downside risks to growth prior to the meeting. Now we have Mishkin, one of the FOMC's chief doves, saying they really are neutral:

In circumstances when the risk of particularly bad economic outcomes is very real, a central bank may want to buy some insurance and, so to speak, "get ahead of the curve"--that is, ease policy more than it otherwise would have simply on the basis of its modal economic outlook. However, because monetary policy makers can never be certain of the amount of policy easing that is needed to forestall the adverse effects of disruptions in financial markets, decisive policy actions may, from time to time, go too far and thus produce unwelcome inflationary pressures. .... If, in their quest to reduce macroeconomic risk, policymakers overshoot and ease policy too much, they need to be willing to expeditiously remove at least part of that ease before inflationary pressures become a threat.

What I just said should serve as a framework for understanding the recent decisions of the Federal Reserve to ease policy, first by 50 basis points on September 18 and then by another 25 basis points last week. The first action was larger than markets expected at the time--indeed, quotes from the federal funds futures market as well as survey data indicated that most investors had anticipated a cut of only 25 basis points in the target federal funds rate ahead of that meeting. As reported in the minutes, the Federal Open Market Committee (FOMC) judged that a policy easing of 50 basis points was appropriate to help offset the effects of tighter financial conditions on the economic outlook. Had the FOMC not eased policy, it would have faced a risk that the tightening of credit conditions and an intensifying housing correction would lead to significant broader weakness in output and employment. In addition, it would have faced the possibility that the impaired functioning of financial markets would persist for some time or worsen, which would create an adverse feedback loop not dissimilar to what I earlier called macroeconomic risk. The cut of 50 basis points at that meeting was the most prudent action from a macroeconomic standpoint, even given the Federal Reserve's objective of price stability. Indeed, with economic growth likely to run below its potential for a while and with incoming inflation data to the favorable side, the easing of policy, even if substantial, seemed unlikely to affect adversely the outlook for inflation.

At the FOMC meeting last week, the federal funds rate target was lowered by another 25 basis points. Our economy grew at a solid pace in the third quarter and was boosted importantly by personal consumption and business expenditures, an indication of considerable underlying strength in spending before the recent financial turbulence. However, the pace of economic expansion is expected to slow in the near term, largely because of the intensification of the housing correction. The combined 75 basis points of policy easing put in place at the past two meetings should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and should help promote moderate growth over time.

Going into the meeting, I was comforted by the lack of direct evidence to date of serious spillovers of the housing weakness and of tighter credit conditions on the broader economy. But with an unchanged policy interest rate, I saw downside risks to the outlook for growth. I was mindful, in particular, of the risk that still-fragile financial markets could be particularly exposed to potential adverse news on the housing situation, or on the macroeconomy more generally, and that renewed strains in financial markets could feed back adversely on economic performance. My vote to ease policy at the meeting was motivated by my wish to reduce those risks. The FOMC perhaps could have waited for more clarity and left policy unchanged last week, but I believe that the potential costs of inaction outweighed the benefits, especially because, should the easing eventually appear to have been unnecessary, it could be removed.

Overall, I think that the cumulative policy easing the FOMC put in place at its past two meetings reduced significantly the downside risks to growth so that those risks are now balanced by the upside risks to inflation. In these circumstances, I will want to carefully assess incoming data and gauge the effects of financial and other developments on economic prospects before considering further policy action.
That's about as hawkish as I've heard Mishkin be since the credit turmoil began. This new hawkishness from one of the Fed's main doves makes it significantly less likely that they'll cut again on December 11. Clearly this neutral stance means they won't cut if growth doesn't slow. But both the Fed and most outside observers expect growth to decelerate significantly in Q4. So here's the big question: What will the Fed do if growth slows as expected? Are they neutral relative to current growth, or relative to their outlook for growth? That is, will they cut if growth slows at all, or only if growth slows more than expected. I bet it's more the former, which isn't really a neutral stance at all.