Fed still likely to pause at the August 8, 2006 FOMC meeting

The weak Q2 GDP report led a lot of people to switch camps and argue for the Fed to pause rather than hike at the FOMC meeting next week. I didn't think the GDP number was that weak, but I retain my position that the Fed is more likely to pause than hike.

The economy has slowed enough that additional hikes are not clearly needed.

The economy is still strong enough that another hike won't kill it or send it "spiraling" into recession.

The economy is also strong enough that even if the Fed "stands pat" and pauses, some further hikes could be needed a few more months down the road.

Although there are so many factors at work, it may be that we can simply use the price of crude oil as a "crude" surrogate for both the state of the economy and inflationary pressure. I would suggest that if crude oil pops up above $80 and stays there going into the August 8 FOMC meeting, a hike will be a done deal. On the other hand, if crude oil retreats closer to $70, a pause will be a no-brainer. Crude oil at $76 to $78 will suggest a higher probability of a rate hike. Crude at $72 to $74 would suggest a higher probability of a pause. The $74 to $76 range is outright "coin flip" territory. Certainly the decision process is nowhere near that simple, but I suspect that my simplistic model won't be too far from being accurate. There are nits such as whether to use "spot" price or front-month futures, or to use the short-term peak futures price, but "headline" or front-month futures (September) are probably close enough.

Where does that leave us today? On Friday, the NYMEX crude oil futures contract for September delivery closed at $73.24 (versus $74.43 a week ago), which is in the $72-74 "no-brainer pause" range. The peak short-term futures contract, June 2007, closed at $77.06 (versus $77.14 last week). Absent significant change this week, crude oil suggests that the Fed will feel reasonably comfortable standing pat with a pause at 5.25%. As long as crude stays below $76, the Fed can pause without too much criticism, but at $76 or higher, the Fed would be feeling the heat and opt to gain more "inflating-fighting" credibility with a hike to 5.50%.

My personal forecast is still for a pause at 5.25%, but that's with an expectation that we could still see some weakening of inflationary pressures (e.g., the price of crude oil) over the coming week. Absent any change in the economy (or oil futures), a pause at 5.25% will evolve into the likely scenario.

I would also note that Fed funds futures are also a decent indicator of what the Fed will do once we're within a few weeks of an FOMC meeting. The September Fed funds futures contract closed at 94.6700, which roughly indicates a Fed funds rate of 5.3300% ($100 minus $94.6700 divided by $100), or closer to 5.25% than to 5.50%. A pause is twice as likely as a hike. I would note that there is a lot of daily and weekly volatility in the trading of Fed funds futures, so it is possibly for the outlook to change over the coming week.

The real "action" in the August 8 FOMC announcement is the tone that the Fed will take on inflation going forward. Hike or pause, I expect the Fed to strike a strong stance on being "vigilant" and ready to pounce with great vigor if they see inflation begin to take flight.

Although much has been made about a presumed 1% to 2% "inflation target" for the Fed, the reality is that 2% to 3% is about "as good as it gets" for the kind of economy and financial system we currently have in America. Sub-2% inflation does in fact occur on occasion, but only in a fleeting manner.

My impression is that once the Fed pauses and considers monetary policy to be "stable", it will be prepared to "hold its fire" if monetary policy is roughly "neutral" (i.e., in the 4.5% to 5.75% range) and one-year inflation doesn't pop too far above 3%. That begs the question of which measure of inflation to use, but in truth it doesn't matter a whole lot. If you want to use headline inflation rather than core inflation, then you simply need to expand the range moderately (say, from 3% to 4.5%) to reflect the nature of volatility due to short-term pricing spikes (e.g., gasoline) that occur no matter what the state of the economy.

-- Jack Krupansky