Sunday, July 16, 2006

Fed now a little more likely to "pause" at 5.25% in August

There was a greater amount of chatter last week that the economy was slowing and Fed funds futures are now a lot less certain about a high probability that the Fed funds target interest rate will be 5.50% after the August 8, 2006 FOMC meeting. To be sure, futures are still pointing to a hike to 5.50% in August, but with significantly less certainty.

As usual, we have to be careful with the last hike forecast by fed funds futures since some number of market participants are probably buying into it as an insurance hedge on their other investments rather than an outright bet that that is what the Fed will really do. Nonetheless, that is where the futures market was on Friday.

I still lean towards the Fed not hiking in August as I expect that inflationary pressures and economic strength will moderate enough over the coming three weeks to lead the Fed to believe that the the lowest risk path is to "pause" at least temporarily to allow past hikes to finish rippling through the economy.

The June 2006 Consumer Price Index (CPI) will be released before the market open on Wednesday. Of course, people should never place an excess of emphasis on the latest data point in a series, but people will in general "set" their inflation expectations for the coming month on this one report. As usual, the core and headline numbers have a good chance of giving conflicting signals, with the headline number boosted by rampant commodities speculation, and the core number usually indicating that real demand for good and services is a bit more muted than the commodities speculators would like us to believe.

A big problem with a lot of these reports is that they will at best give us a rear-view mirror picture of the economy back in June, but give us little insight into the state of the economy in July, let alone going forward.

Plus or minus a quarter-point will have a negligible overall economic impact on the national economy. "Pausing" would have more of a psychological effect, signalling people that they no longer have to continue to prepare for the pain of even higher interest rates in the months ahead.

Quite a few people are acting "as if" the Fed had already decided to hike by a quarter point to 5.50% in August, thus giving the Fed a free ride and having the psychological effect of an extra quarter-point in place today that actually doesn't exist, yet.

There is still a good chance that inflationary pressures will remain relatively robust over the coming month, in which case the markets and the Fed will likely be persuaded that yet another quarter-point hike (to 5.50%) is the least-risk path. I certainly don't see inflation accelerating over the coming months, but whether it decelerates enough to recede to closer to the mid-point of the Fed's implied target of 1% to 2%, from its current level of around if not above the upper end of that range, is a matter of intense conjecture.

In summary, any Fed action or inaction in August is certainly not preordained, but critically dependent on "incoming data", including official economic reports, private economic reports, anecdotal reports from the regional Fed banks (e.g., the Beige book), commentary by businesses on their sales and investments, and computer forecasting models as well. And ultimately it will be a purely seat-of-the-pants call by the FOMC and the Fed chairman themselves.

Although in some ways it "feels" right now as if a hike to 5.50% is "the right thing", that is partly a matter of driving by looking in the rear-view mirror and using our past feelings as a crystal ball for the future, which is a really bad thing to do. We need to focus much more intently on "the ball" right in front of us and use "incoming data" and other leading indicators to make judgments about the future. If we get even a couple more reports weak reports, we could see people quickly shift to expectations for a definite  pause at 5.25% after the August FOMC meeting.

The retail sales report from last week was touted as being weak, but this is another one of those reports which has two important numbers, the headline number, which was a bit weak, plus the ex-auto number which was reasonably decent. Once again, we have mixed signals, plus the caveat that we shouldn't place too much emphasis in the latest data point in a series.

Since a single quarter-point delta in interest rates isn't that critical, one could argue that the Fed should go for one more hike "for good measure" and to make it crystal clear to people that stomping out inflation is "Job #1" for the Fed. On the other hand, any developing weakening of the economy could just as quickly put the Fed back into the mode of trying to prop up sagging growth.

The growth rate of the Weekly Leading Index (WLI) from the Economic Cycle Research Institute (ECRI) has weakened significantly over the past  eight weeks (from +3.5% to +0.2%), although the actual level of the index has been rising lately and is at it's highest level in a month. A WLI of zero (0.0) would indicate an economy that is running at a steady growth rate, neither accelerating nor decelerating. A WLI fluctuating in a range from +1.5% to -1.5% would seem to be a relatively stable "Goldilocks" economy. Although the WLI growth rate is at its lowest level since a year ago, the index did tick up nicely last week and isn't showing any signs of the kind of persistent weakness (values more negative than -1.5%) that would be seen in an economy that was slowing on its way into recession, but does look a lot like an economy moderating on its way to a relatively stable growth rate. If I were looking at this one indicator alone, I'd say that the Fed could safely flip a coin as to whether to hike in August.

-- Jack Krupansky


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