Sunday, August 06, 2006

Fed likely to pause at 5.25% the FOMC meeting on Tuesday

A lot of people are now believing that the pace of the economy has slowed sufficiently that the Fed can safely pause at 5.25% at the FOMC meeting on Tuesday.

Fed funds futures contracts for September suggest a target interest rate of 5.31%, which is much closer to 5.25% than to 5.50%. In fact, September futures suggest only a 24% chance of a hike to 5.50% on Tuesday.

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 $74.76 (versus $73.24 a week ago), which is modestly above the $72-74 "no-brainer pause" range. The peak short-term futures contract, July 2007, closed at $79.04 (versus $77.06 last week). Absent significant change this week, crude oil suggests that the Fed will lean towards standing pat with a pause at 5.25%, but might well go for the eqtra quarter-point hike as a form of inflation insurance. 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%. There was an extra "hurricane" premium in the price of crude oil due to Tropical Storm Chris. Much of that premium reversed, but not all of it since we have a couple more months of hurricane season in front of us.

My personal forecast is still for a pause at 5.25%. Absent any change in the economy (or oil futures), a pause at 5.25% will be the likely scenario.

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.

Fed Chairman Bernanke hinted at his last congressional appearance that the Fed may have gone far enough, that the economy has slowed somewhat, and that the effects of previous hikes have not completely propagated through the economy. The market has since adapted that view. Most importantly, no officials have disputed that view. Pausing at 5.25% seems consistent with the Fed's pronouncements and the market's actions.

On the other hand, it might come down to whether the Fed feels that it needs to establish "hawkish" inflation-fighting credentials by going for one more hike, especially in light of persistently elevated crude oil and gasoline prices. I think not, but it is certainly possible.

In short, my position remains that the Fed will hold its Fed funds target interest rate at 5.25% at the FOMC meeting on Tuesday, but will include wording that argues for vigilance and may even caution that further action may be needed if any additional inflationary pressure emerges in the coming months.

-- Jack Krupansky


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