Saturday, August 19, 2006

Fed still likely to remain paused at 5.25% for the rest of the year and next

As of Friday, Fed funds futures were predicting that the Fed will remain paused at their September20, 2006 meeting. October Fed funds futures predict a rate of 5.2850%, or about a 14% chance of a hike and an 86% chance of no hike.

Further out, Fed funds futures predict a rate of 5.330% in December, suggesting less than a 1 in 3 chance of a hike to 5.50% in December. Even in January futures predict a rate of 5.340%, or only a 36% chance of a hike. Note that futures less than 45 days out tend to have some chance of accuracy, but further out futures are susceptible to very wild swings and changes in market sentiment and frequently reflect insurance hedges rather than outight bets.

My estimates are very rough calculations based on Fed funds futures prices. More accurate modeling of fed funds rate predictions based on options on federal funds futures can be found on the the Cleveland Federal Reserve Bank's web page for Fed Funds Rate Predictions. Based on their calculations from Thursday, there is a 84% probability of 5.25% after the September meeting, and a 72% probability of a 5.25% rate after the October meeting. I'm sure that their sophisticated modeling and math is far more rigorous than mine, but the final number is still in the same ballpark and still has the same overall message: no hike at either the September or October FOMC meetings.

My unchanged view is that although the Fed has a strong preference for inflation in the 1% to 2% range, even the 3% range is somewhat tolerable, at least for a a relatively short span of months or maybe even a year. Even with the most recent spike, oil prices still haven't advanced significantly beyond their peak for the year to date. Ditto for gasoline. Speculators are still bullish on commodities, but overall, commodities prices have lost much of their upward momentum.

It may take a number of months or even an entire year for inflation to pull back into even the 2% to 3% range, but the Fed has in fact done all of the heavy lifting and now has the luxury of sitting back and watching the fruits of its labors gradually take root.

General points:

  • 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 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 September 20 FOMC meeting, a hike will be a done deal. On the other hand, if crude oil retreats closer to $70, a continued 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 staying paused. 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 $71.14 (versus $74.35 a week ago), which is clearly in the "no-brainer pause" range. October crude closed at $72.10 and becomes front month on Tuesday, but it also is in the "no-brainer pause" range. The peak short-term futures contract, August 2007 and September 2007, closed at $76.00 (versus $78.86 last week). Absent significant change over the coming weeks, crude oil suggests that the Fed will stand pat with a pause at 5.25%. As long as front-month crude stays below $76, the Fed can remain paused 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%.

The hurricane season has been very mild this year to date, but I said that last year at this time and then Katrina and Wilma came along. You can be sure that traders and speculators and planners will be hyper-alert for storm-related news, so we might not see crude oil futures pull back significantly until we get well into October. We could also see one or more "technical" pullbacks based of technical analysis by traders and speculators, but they tend to be following by matching rallies, until we finally see an economically-based decline.

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. Bernanke also made clear during his confirmation hearings that he was inclined to stick with the status quo for now and move towards specific inflation targets only over time. So, don't worry about such a target this year and probably even next year.

My impression is that once the Fed pauses for several meetinsg 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.

Before the August FOMC meeting it was not clear whether Bernanke would lean more heavily in the hawkish inflation-fighting direction or in the more dovish growth-promotion direction. The pause at the August FOMC meeting made it abundantly clear that despite being serious about fighting inflation, he prefers to protect growth. Put another way, he probably despises inflation a little less than he despises deflation.

Another factor that cannot be overlooked is that this is an election year, and there is a tendency (but not a hard rule) that the Fed should "lighten up" going into a politically-charged election season and avoid appearing to be helping one party or the other. I personally don't think that this was a major factor in the Fed's thinking or will be in the next two months, but this factor is out there.

My view is that the Fed will keep their fed funds target rate paused at 5.25% for at least the rest of the year, and probably for the entire coming year.

-- Jack Krupansky


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