Bernanke Drops the Ball

OK -- it's been a few days, and in the meantime the markets have decided to hyperventilate about the Bernanke presser.  So, let's take a minute to look at exactly what he said and what it means.

Starting about 4:30, Ben explains the two programs the Fed is using.  The first is interest rate policy, which is still going to be low for a long time.  Here's the exact wording from the Fed statement: In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

So, we have a three-pronged set of factors to use when evaluating when rates may increase: unemployment about 6.5%, future inflation is lower than 2.5% and inflation expectations are well anchored.  Ben specifically notes these are thresholds, not targets, so even if we do hit those targets, rates could stay low.

Let's turn to the asset purchase program, which he starts explaining at 8:00.  Currently, the Fed is purchasing assets at the following monthly pace: $45 billion in Treasuries and $40 billion in agencies.  The fed may moderate this later in the year, with the potential to end the program by next summer.  He notes the pace is not predetermined, but instead is highly dependent on incoming economic information.  If the economy improves, the pace will quicken; if the economy slows, the pace will slow or the program will end entirely.

Let's place the asset purchase program in historical perspective by looking at the 10-year CMTs interest rate:

The 30-year bull market in bonds is still intact.  We do see a slight uptick on the long-term chart, which is better analyzed using a shorter time frame:

 Rates have moved about 2% and are now approaching 2.5%.  While this rate is still low, that lowness is relative.  In comparison to our recent rate experience, it's actually getting high.

Also note the Fed will continue to reinvest maturing principle (see statements beginning at 9:30).  This could be a key point, as the Fed may think they have enough financial ammunition already on their books to keep rates low. 

For more on the overall effect, see NDDs piece below.

Now let's entertain the question of whether or not this is a good idea right now, starting with an obvious although overlooked point: asset purchases have to end sometime, it's a matter of when.  Now -- is this time the appropriate time?  Ben notes that unemployment has dropped since the plan was initiated.  He also sees current moderate growth.

Here's where I think he makes a big mistake, quoting from the Fed release. The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall.  I don't think this is the case at all.  Consider the following points.

The fed admits that we're facing fiscal headwinds thanks to the bozos in Washington ("fiscal policy is restraining economic growth.").  Manufacturing is slowing thanks to a slow international environment and general tentativeness domestically.  One of the key bright spots in the economy is housing, which the Fed's move will hurt by increasing interest rates.  Wages aren't going to meaningfully increase in a 7.5% unemployment environment and refis -- which have been proving a fair amount of the financial fuel for consumer purchases (see NDD below) -- are going to drop in a higher rate environment.

And the international environment is terrible.  The EU -- which is the second largest economic region after the US -- is in a depression.  China is clearly slowing, which is having a pronounced negative effect on the developing world.   The three other BRICs are all experiencing their own problems: India has slower growth, high current account deficits, systemic political paralysis and high inflation.  Brazil's growth is slowing and their inflation in far higher than preferred, meaning their central bank can't lower rates to stimulate growth.  And Russia is fast becoming a basket case.

In short, I think the Fed is dropping the ball on this one.

 

1955: Interest Rates, Inflation and Fed Policy

 

Remember that during 1955,  the economy was growing at very strong rates.  As the economy expanded, businesses increased their borrowings.  In addition, as the economy expanded, the Fed became more and more concerned with inflation.  This is the reason for the increase in the discount rate during the year.  Consider the following excerpts from various rate decisions by the Fed:

From April 13: 

August 3:

November 17:

However, prices were in fact pretty contained:

The bottom whole sale price chart shows that crude goods were decreasing in price.  The real price pressure was coming at the intermediate price level, but producers were able to absorb that cost, as evidenced by the slow rise of finished goods prices.  The top chart shows that food prices were dropping sharply, while other prices were moving higher.

Consumer prices were also pretty contained.  The primary area where we see an increase are in services, which is to be expected; this year -- and this decade -- saw a tremendous increase in service usage on the part of consumers.  As the US started to form households, they purchased more and more goods such as dry cleaners, yard services etc....

1954: Prices and Fed Policy

Prices were incredibly subdued in 1954.  Consider the following charts:

The year over year percentage change in PPI was mild for the first half of the year and negative for the second -- albeit very slightly negative.

The year over year percentage change in CPI showed the exact same pattern as PPI.

Also consider these price charts from the 1954 Federal Reserve policy review:

Remember that in early 1951, Congress passed a price control act as a way to prevent price spikes during a time of war.  Also remember that there were wage and price panels that monitored and set prices for a bit of time after the passage of that act.

However, as prices were contained, interest rates dropped:

1952: Inflation and Fed Policy

This posting is part of the Bonddad Economic History Project 

CPI was quite moderate.  The YOY percentage change started at 4% and slowly decreased throughout the year to a little under 1%.  Now, this type of deceleration can also be a sign of a potential recession on the horizon, which did start in the 3Q of 1953.

The YOY percentage change in PPI was negative for the entire year, indicating the input prices were dropping.

The above charts shows the absolute PPI level for the year, which shows the drop more completely.

As a result of the stable inflation picture, we see that the Fed did not raise rates in 1952. We also see that interest rates were fairly steady, with the exception of the continued upward movement of Treasury Bills, which jumped higher at the end of the year.  The Fed explained the increased as an increased demand for loans at the end of the year.

The above table shows the increase in various types of loans over the year.  Note the slow pace at the beginning of the year, while we see a big bump in the 4th quarter.  We see two reasons for the increase.  Business loans increased, with almost all of the increase coming in the fourth quarter.  In addition, "other loans to individuals" increased by $2.2 billion , but this increase came from a strong growth in the second, third and fourth quarters (for more on the increase in consumer credit, see the 1952; PCE post).

The above tables shows that corporate security issues rose strongly in 1952, and competed for commercially available capital.  The increase in 4th quarter lending was probably partially caused by an inability to complete an offering prior the end of the year.  Again, note the large increase in consumer credit.

In short, what we see here is a fairly stable financial system. 

1951; Prices and Fed Policy

This is part of the Bonddad Economic History Project

Remember that the early 1950s saw tremendous growth in consumer demand and employment growth (see here and here).  Hence there is s tremendous amount of demand pull inflation in the economy.  In addition, the US is now producing for a massive war effort, which greatly increases the demand of basically every raw material.  As such, inflation increases.  Yet, in 1951 we see a decrease in inflation, which leads to the question, why?

Price controls.  In 1951, Congress passed the General Ceiling Price Regulation of 1951, which froze prices at their highest level reached in late December 1950 and late January 1951. 

Also of extreme importance this year was the Treasury Fed-Accord of 1951, which was:

Agreement between the U.S. Treasury Department and the Federal Reserve Board of Governors that enabled the Fed to pursue an active Monetary Policy, independent of the Treasury and the federal government. Before 1951, the Fed had to assure low cost Treasury financing by purchasing Treasury securities at a set price. Afterward, the Federal Reserve Open Market Committee was able to purchase as much, or as little, of Treasury securities offered for sale by the Treasury Department as it wanted, instead of having to buy whatever the Treasury issued at the prevailing rate. Also known as the Treasury-Fed Accord.

You can read a more complete history at the Richmond Fed.

In short, the Fed no longer had to buy bonds at set prices; as such lenders could no longer count on
the Fed to purchase bonds whenever they (the lenders) needed to extend credit.  As such,

While the Fed did not raise the discount rate, they did increase the reserve requirements for banks, and the margin account requirements for stock purchasers.  They also tightened installment credit terms and real estate lending.  In addition, there was also a voluntary restraint on "non-essential lending, related to war activity.

The charts below, from the Federal Reserve report, show the changes in overall credit for year.

Business loans still grew at a strong rate, largely thanks to loans for essential war activity.  The constraints on consumer lending show clearly on the chart (and below, which show a small .1% increase in consumer lending) as does the constraints on mortgage credit.

The above chart shows the overall upward drift of interest rates in the government security areas, which was primarily caused by the new arrangement between the Fed and the Treasury department.

Finally, consider the following charts of inflation from the 1952 Economic Report to the President.

Fed Unveils New Lending Facility

From Marketwatch:

The Federal Reserve on Tuesday unveiled its new Term Asset-Backed Securities Loan Facility (TALF), a plan under which it will lend up to $200 billion to support the issuance of debt backed by consumer and small business debt like credit card loans, student debt, auto loans and loans backed by the Small Business Administration (SBA). The Fed hopes the plan will create liquidity in the market for securities backed by the receivables from such loans, which in turn would encourage originators of consumer loans to restart lending to individuals.

But that's not all:

The central bank will purchase as much as $600 billion in debt issued or backed by government-chartered housing-finance companies. It will also set up a $200 billion program to support consumer and small-business loans, the Fed said in statements today in Washington.

What the Fed is trying to do is jump-start the securitization market for consumer debt. When a credit card company issues a certain amount of cards, it takes the accounts and securitizes them much in the same way mortgages are securitized. However, the entire credit market has seized up, including the consumer market. As a result consumer credit issuance is tight.

But with this new lending facility comes added stress on the Fed. Consider the following points from this week's Barron's:

IF THE FEDERAL RESERVE BANK WERE A COMMERCIAL LENDER, it would be a candidate for receivership, based on its capital ratios. Bank examiners generally view any lender with a ratio below 2% to be dangerously undercapitalized. The Fed's current capital ratio, or capital as a percentage of assets, is 1.9%.

The Fed has provided so many loans and emergency credits -- to banks, brokers, money funds and foreign countries -- that its balance sheet, viewed one way, is as leveraged as any hedge fund's: Its consolidated assets amount to 53 times capital. Only 11 months ago, its leverage on this basis was a more modest 25 times, and its capital ratio 4%. A caveat: Many of the loans are self-liquidating facilities that will disappear in a few months if the financial crisis eases.

Although the Fed's role as a central bank is much different from the role of a private-sector operation, the drastic changes in the size and shape of its balance sheet worry even some long-time Fed officials. Its consolidated assets have swelled to $2.2 trillion from $915 billion in about 11 months, and contain at least a half-dozen items that weren't there before. Some, like a loan to backstop the purchase of a brokerage, Bear Stearns, are unprecedented. (See table for highlights.)

Critics say this action could hinder the Fed in achieving its No. 1 priority: keeping inflation in check. To try to get in front of the crisis, many decisions have had to be made on the fly.

"If the Fed had been [a savings-and-loan] ballooning its balance sheet so fast, the supervisors would have been all over it," says Ed Kane, a Boston College finance professor.

Here is an accompanying graphic:



Click for a larger image

While these are extraordinary times, that does not mean conventional rules of risk management do not apply in one way or the other.

Bernake on the Economy

From his speech last night

Before turning to those issues, however, I would like to provide a brief update on the outlook for the economy and policy, beginning with the prospects for growth. Despite the unwelcome rise in the unemployment rate that was reported last week, the recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly. Indeed, although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so. Over the remainder of 2008, the effects of monetary and fiscal stimulus, a gradual ebbing of the drag from residential construction, further progress in the repair of financial and credit markets, and still-solid demand from abroad should provide some offset to the headwinds that still face the economy. However, the ongoing contraction in the housing market and continuing increases in energy prices suggest that growth risks remain to the downside.

What Bernanke is arguing -- correctly I think -- is there are two sets of forces at work.

On one hand we have a bottoming in housing, credit market repair and exports helping to ameliorate the effect of high energy prices and the housing slowdown. Some of this hangs on when housing will bottom out, and as I have repeatedly asserted, I don't see that happening anytime soon. Simply put, supply is still massive, demand is still weak and lenders are facing tremendous headwinds from a tightening of their balance sheets. These are not conditions conducive to healing.

Oil's chart has been rising since early 2007. That's a strong rally to kill. In addition, the summer months are typically a period of higher prices, so we're arguing against a strong historical trend. In addition, we've got 2 billion people (India and China) with higher standards of living. So I don't see that dropping anytime soon.

The only good news here is in exports, which should do well so long as the dollar remains cheap. And given the sorry state of the Federal government's finances, I don't see that changing anytime soon.

Now They're Woried About Inflation

From the WSJ:

Federal Reserve officials are acknowledging increasing weakness in the economy, signaling a willingness to cut rates again at their next meeting. But inflation concerns are rising among some officials, indicating the magnitude of their next move may be a matter of contention.

.....

Some officials, however, expect growth to rebound in the second half, and they are wary of cutting rates so low now that they would spur higher inflation as the economy recovers. Monetary policy works with a lag, so interest-rate cuts tend to boost the economy six months to a year after they are implemented.

"The Fed has to be very careful now to add just the right amount of stimulus to the punch bowl without mixing in the potential to juice up inflation once the effect of the new punch kicks in," Richard Fisher, president of the Federal Reserve Bank of Dallas, said in a speech in Mexico City yesterday. Mr. Fisher dissented in the Fed's latest vote, which lowered the interest-rate target half a point.

Charles Plosser, president of the Federal Reserve Bank of Philadelphia who also is on the voting rotation this year, suggested this week that he would need to see a deeper deterioration in the economy -- beyond the weak numbers already expected -- to support further easing.

But Mr. Plosser, who backed the last two rate cuts, said he expects "little progress" in lowering a key inflation measure this year or next, "and I am skeptical that slower economic growth will help," he said. "All you have to do is recall the 1970s when we experienced both high unemployment and high inflation to appreciate that slow economic growth and lower inflation do not necessarily go hand in hand."

This has been one of the main reasons I have argued against the rate cuts over the last few months. The bottom line is inflation is nowhere near a good level.

Here is a chart of the year-over-year change in inflation:



And here is a chart of the year-over-year change in money growth



Inflation looks really tame, doesn't it (end really sarcastic, smart-ass tone)

I first started to become concerned about inflation after my twice weekly shopping trips. I noticed that things I buy regularly -- milk and chicken -- were increasing in price to uncomfortable levels. In Houston Texas, a gallon of milk was roughly $2.99/gallon for the longest time. Over the last 6 months it has increased in price to $3.39/gallon. Bonless skinless chicken has increased from approximately $5.50/package (roughly 4 chicken breasts) to over $7.00 package. Then I started to listen to check-out conversation and it was all centered on prices. I realize the Bonddad's shopping list is hardly exciting reading, but this is where my concern started.

Now we have stories like these about agricultural prices hitting record highs and inflation hedging commodites like gold and sliver doing likewise. Anyone who follows these markets -- wheat, corn and the like -- has seen huge price increases over the last 5-7 years. While the Fed was concerned about "core" inflation -- great if you don't eat or drive anywhere but completely useless for anything else -- non-core inflation was running through the roof.

And it's not as though interest rates were sky high in the first place. Take a look at the following charts from the St. Louis Federal Reserve:

Effective Federal Funds:



10-Year CMT



30-Year CMT



AAA Corporate paper



BBB Corporate paper



Interest rates are cheap beyond belief. It's not as though money is expensive right now. The central problem isn't the cost of money -- it's a poorly managed financial sector. But thanks to 17 years of Alan "cheap money" Greenspan, we're all use to the Fed cutting rates whenever we feel economic pain. Thanks for nothing.

So now we hear the Federal Reserve actually talking about inflation. That's nice. It's what they should have been talking about all along.

About The Fed Auctions

From IBD:

The Fed said banks submitted 93 bids totaling $61.553 billion for the $20 billion in loans auctioned off Monday. That put the bid-to-cover ratio at a little more than 3-to-1.

.....

Jay Bryson, global economist with Wachovia, said the strong auction demand was positive.

"It shows that there's not a stigma attached to this as there was at the discount window and that banks are willing to come to the Fed directly," Bryson said.

The interest rate on the 28-day loans — set by the bidding process — was 4.65%. That's higher than the fed funds target rate of 4.25% for overnight bank loans. But it's below the 4.75% discount rate.

.....

Scott Brown, chief economist with Raymond James, said that at this early stage the results of the Fed's first auction are still somewhat hard to interpret.

The heavy demand for the auction loans "suggests either that there's a huge need for (the auction) or that it's working," Brown said. "You need to see the results in the credit markets in the next few days — the Libor (market) in particular is the one to watch."

Mr. Brown has the right take; it's still way too early to tell whether this will work or not.

Let me add a few points.

1.) I've said it before, and I'll say it again; this isn't about liquidity -- it's about confidence. When lenders are concerned that borrowers will take a financial hit over the period of a short-term loan, then lenders are going to be reluctant to lend. In addition, lenders have every reason to be concerned about their own balance sheets right now. Just yesterday, Morgan Stanley announced a writedown of $9.4 billion and S$P downgraded insurer ACA to junk status. In other words -- there are still a ton of problems out there in the financial market.

2.) The Fed is in a serious policy bind. Let's assume this plan works -- then great, the Fed is the champion. But if the plan doesn't work, what can the Fed do then? The latest CPI and PPI reports seriously hem the Fed in from a policy perspective. My opinion is the Fed opted for this plan because of the high inflation levels reported last month.

3.) This reset chart



shows one clear point: this problem is just getting started. Estimates for the total amount of losses range between $300 billion and $500 billion. So far, we've seen about $80 billion in writedowns. That means we've got a ways to go before we're out of the woods.

What We Have Here is a Failure to Communicate

The markets were very disappointed with the Fed's decision. Immediately after the announcement, the markets sold-ff hard. Looking back at the most recent Fed speeches, it's easy to see why the markets were so unhappy.

Notice these statements from Janet Yellen:

For example, there continues to be a strong demand to hold U.S. Treasury securities—which are the safest and most liquid in the world—leading to Treasury yields that are much lower than they were before the shock hit in mid-July. Of course, one reason for the decline in Treasury yields is that the Fed has cut the federal funds rate and the market expects substantial additional cuts in the future, reflecting the view that policy will ease further to offset the contractionary effects on economic activity of the financial turmoil. But another important reason is that there has been a worldwide “flight to safety.” Stated differently, the spreads of most risky assets above Treasuries have risen.

.....

Likewise, the cost of insuring investors against default on securities they hold, through derivatives known as credit default swaps, has jumped again in recent weeks and is far higher than normal.

.....

The mortgage market has been the epicenter of the financial shock, and, not surprisingly, greater aversion to risk has been particularly apparent there, with spreads above Treasuries increasing for mortgages of all types.

.....

Moreover, many markets for securitized assets, especially private-label mortgage-backed securities, continue to experience outright illiquidity; in other words, the markets are not functioning efficiently, or may not be functioning much at all. This illiquidity remains an enormous problem not only for companies that specialize in originating mortgages and then bundling them to sell as securities, but also for financial institutions holding such securities and for sponsors, including banks, of structured investment vehicles—these are entities that relied heavily on asset-backed commercial paper to fund portfolios of securitized assets.

.....

Depository institutions are increasingly facing challenges.

None of these developments is good. More importantly, these statements added to the belief that the Fed would address the problems in the market.

Fed President Kohn's statements added to the markets expectations:

At the same time, the term interbank funding markets have remained unsettled. This is evident in the much wider spread between term funding rates--like libor--and the expected path of the federal funds rate. This is not solely a dollar-funding phenomenon--it is being experienced in euro and sterling markets to different degrees. Many loans are priced off of these term funding rates, and the wider spreads are one development we have factored into our easing actions. Moreover, the behavior of these rates is symptomatic of caution among key marketmakers about taking and funding positions, and this is probably impeding the reestablishment of broader market trading liquidity. Conditions in term markets have deteriorated some in recent weeks. The deterioration partly reflects portfolio adjustments for the publication of year-end balance sheets. Our announcement on Monday of term open market operations was designed to alleviate some of the concerns about year-end pressures.

And then there are Bernanke's statements:

With respect to household spending, the data received over the past month have been on the soft side. The Committee will have considerable additional information on consumer purchases and sentiment to digest before its next meeting. I expect household income and spending to continue to grow, but the combination of higher gas prices, the weak housing market, tighter credit conditions, and declines in stock prices seem likely to create some headwinds for the consumer in the months ahead.

Core inflation--that is, inflation excluding the relatively more volatile prices of food and energy--has remained moderate. However, the price of crude oil has continued its rise over the past month, a rise that will be reflected in gasoline and heating oil prices and, of course, in the overall inflation rate in the near term. Moreover, increases in food prices and in the prices of some imported goods have the potential to put additional pressures on inflation and inflation expectations. The effectiveness of monetary policy depends critically on maintaining the public’s confidence that inflation will be well controlled. We are accordingly monitoring inflation developments closely.

The incoming data on economic activity and prices will help to shape the Committee’s outlook for the economy; however, the outlook has also been importantly affected over the past month by renewed turbulence in financial markets, which has partially reversed the improvement that occurred in September and October. Investors have focused on continued credit losses and write-downs across a number of financial institutions, prompted in many cases by credit-rating agencies’ downgrades of securities backed by residential mortgages. The fresh wave of investor concern has contributed in recent weeks to a decline in equity values, a widening of risk spreads for many credit products (not only those related to housing), and increased short-term funding pressures. These developments have resulted in a further tightening in financial conditions, which has the potential to impose additional restraint on activity in housing markets and in other credit-sensitive sectors. Needless to say, the Federal Reserve is following the evolution of financial conditions carefully, with particular attention to the question of how strains in financial markets might affect the broader economy.

The Federal Reserve's speeches were (and still are) very clear. They see a deteriorating situation in the economy and a worsening picture in the credit markets. Yet -- they did very little to alleviate either problem. The cut in the discount rate merely maintained the current Fed funds/discount rate spread. This implies the Fed really doesn't see the current credit market situation as a problem. And the 25 basis point cut seems too little in light of the Fed's last three public statements.

Now, in the Fed's defense there are two issues to consider. One is the dollar, which has been dropping hard since the Fed's last two cuts. A 50 BP Fed funds cut may have seriously damaged the dollar, sending it lower still. The second is inflation from food and energy prices, which the Fed specifically mentioned in their statement yesterday. Yet both of these issues were near absent from the Fed's pre-meeting public discussions. The dollar was completely absent and inflation was by far a secondary topic in relation to the credit market issues which took clear center stage.

The bottom line is the Fed screwed this one up big time. They told the markets the Fed was really worried about the credit markets but then didn't do much to alleviate those problems. Then the Fed said the economy is in trouble yet only cut rates by 25 basis points. This is why the markets tanked hard after the announcement. The Fed set the markets up and then dropped the ball in a big way.

European Bankers Have the Right Idea; Fed Bankers Don't

From Bloomberg:

European Central Bank officials said food costs and record oil prices are fanning inflation pressures in the 13 euro nations, suggesting they may support further interest-rate increases.

``Inflation risks have increased recently'' and the ECB will ``have to counter these risks should they materialize,'' said Germany's Axel Weber in an Oct. 20 interview after a meeting of the Group of Seven nations in Washington. Austrian colleague Klaus Liebscher said the threat of faster inflation is ``significant.''

...

Trichet said Oct. 19 it's ``clear'' a further increase in energy costs will have ``an inflationary impact.'' Liebscher said ``there is no relaxation concerning the risks to price stability, it's the other way around.'' Greece's Nicholas Garganas said he's also concerned about prices in 2008.

Policy makers said the surge in energy costs is likely to keep inflation above the ECB's limit this year and next. Weber said futures markets show investors expect the cost of crude to stay ``above what we had based our projections on.''

Compare the above to this:

Federal Reserve Governor Frederic Mishkin said inflation measures that exclude food and energy costs are a ``better guide'' to underlying changes in prices.

Changes in price indexes without food and energy ``provide a clearer picture of underlying inflation pressures,'' Mishkin said in the text of remarks to the HEC Montreal Macroeconomics and Monetary Policy Conference today. ``If the monetary authorities react to headline inflation numbers, they run the risk of responding to merely temporary fluctuations.''

Mishkin argued that both so-called core and headline measures of inflation are useful to policy makers and the central bank shouldn't rely on any one gauge. Sustained increases in energy costs can push up expectations for inflation, he said, noting that recent gains in oil are a ``reminder that shocks can persist longer than one might have first expected.''

One set of central bankers can read a chart like this one:



And this one:



One set of central bankers either can't read a chart or doesn't think the above charts are that important.

The WSJ Sums Up the Fed Governor's Speeches

For those of you keeping score at home:

Here’s a quick run-down of all the recent Fed speeches:

* Hawk St. Louis Fed’s William Poole, Sept. 6: “The extent to which it’s affecting the broader economy…I don’t think we know yet. We shouldn’t take for granted the assumption that the economy is about to take a nose-dive.”

* Hawk Atlanta’s Dennis Lockhart, Sept. 6: “So far, I have not seen hard or soft data that provide conclusive signs that housing problems are spilling over into the broad economy…In my view current readings of inflation represent progress, but not victory. I would like to see inflation sustained at a somewhat lower rate—with emphasis on “sustained.”

* Hawk Philadelphia’s Charles Plosser, Sept. 8: “Going forward, until housing demand picks up and some of the inventory of unsold homes is worked off, residential construction will continue to be a drag on economic growth. I expect this drag to diminish gradually but continue until sometime next year. I believe the most likely outcome is that economic growth will return toward trend later in 2008.”

* Dove San Francisco’s President Janet Yellen, Sept. 10: “I see significant downward pressure based on recent data indicating further weakening in the housing sector and the tightening of financial markets… should the decline in house prices occur in the context of rising unemployment, the risks could be significant… signs of improvement in underlying inflationary pressures are evident in recent data… past experience does show that financial turbulence can be resolved more quickly than seems likely when we’re in the middle of it. Moreover, the effects of these disruptions can turn out to be surprisingly small.”

* Hawk/Dove Mr. Lockhart, Sept. 10: Friday’s employment figures “clearly have to be taken very seriously,” but added that he “would like to see inflation sustained at a somewhat lower rate.”

To recap — that’s three speeches on the side of hawkishness, one that sort of straddles the middle (Mr. Lockhart, today), and another that is mostly dovish, although not strongly so (Ms. Yellin, today), which suggests that market players betting on Fed rate cuts would probably want to lean to the quarter-point area.

Personally, I have no idea what the Fed is going to do. However, there are a ton of positions out there.

There is something that I find extremely interesting -- and this is simply an observation. It seems that various Fed members have more latitude to speak their mind under Bernanke. We are seeing a fairly wide divergence of opinions expressed.

In addition, there does seem to be a concerted effort to demonstrate the Fed does not want to bail-out the Street if the damage has not migrated outside of the financial markets. That tells me they are very aware of the perception that people would have of them granting a pass to all of the stupid credit practices that have occurred over the last few years. I may be reading too much into that (or maybe I want to see that).

Fed Officials Upbeat

From Marketwatch

Federal Reserve officials said Thursday that current economic conditions are good and the financial turmoil hasn't hurt Main Street.

In a luncheon speech to the Atlanta Press Club, Atlanta Federal Reserve President Dennis Lockhart said there are no signs of spillover from the housing and mortgage market woes into other sectors of the economy such as consumer spending.

Lockhart said his comment relied on real-time information from business contacts around the South because much of the new government indicators are "backward looking."

"So far, I have not seen hard or soft data that provide conclusive signs that housing problems are spilling over into the broad economy," Lockhart said.

His remarks echo the sentiment in the Fed's Beige Book report on current economic conditions that found that growth continued across the country at a moderate pace through August with little sign that the credit crunch and financial turmoil have slowed activity. See full story.

But in an earlier statement to reporters following a speech in London, St. Louis Fed President William Poole said the risks of recession have risen as a result of the market turmoil. But Poole said, "I don't think we should take for granted that the economy is going to nosedive."

Later in the afternoon, Dallas Fed President Richard Fisher was upbeat about current conditions.

In answer to a question after a speech in El Paso, Fisher said recent economic data has been "rather positive," and pointed specifically to the August ISM services index, which was unchanged at 55.8%.

Let's make an assumption that Fed governors are in regular contact with one another. In addition, let's also assume they loosely coordinate their public statements. That would make sense at a time like this with everybody looking to the Fed to cut rates later this month. If all of those points are true then a rate cut is not a definite possibility.

So, let's assume the Fed doesn't act. What happens to the market? My guess is a day or two of selling but nothing drastic. After the initial sell-off, my guess is traders would come to the opinion there was no reason for the Fed to cut, meaning things aren't as bad as perceived. I have no idea if that is what will actually happen, but it makes sense. Non-action means the economy is doing fairly well.

Here's how Bloomberg reported the speeches:

Four regional Federal Reserve bank presidents declined to endorse a cut in the benchmark interest rate this month, as policy makers gauge the impact of the credit- market rout on the U.S. economy.

The markets are probably not happy about this development.

Fed Still Focused on Inflation

From the Federal Reserve

At its May meeting, the Federal Open Market Committee (FOMC) maintained its target for the federal funds rate at 5-1/4 percent. The Committee’s accompanying statement noted that economic growth slowed in the first part of the year and that the adjustment in the housing sector was ongoing. Nevertheless, the economy seemed likely to expand at a moderate pace over coming quarters. Core inflation remained somewhat elevated. Although inflation pressures seemed likely to moderate over time, the high level of resource utilization had the potential to sustain those pressures. The Committee's predominant policy concern remained the risk that inflation would fail to moderate as expected. Future policy adjustments would depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

The Fed has been saying the same thing for about 6 months now. No one should be surprised by this statement.

WSJ Gets The Fed Right

From the WSJ:

On May 9, the Fed left its short-term interest-rate target at 5.25%, where it has stood since last June. It released a statement reiterating that inflation remained its predominant concern and that policy makers considered inflation "elevated." That surprised some observers, given prior data showing inflation had slowed a bit.

The more confident outlook about economic activity would appear to diminish the odds that the Fed will cut interest rates in coming months. "Policy is on hold for as far as the eye can reasonably see," Joshua Shapiro, chief U.S. economist at consulting firm MFR Inc., said in a note to clients.

The Fed's continued focus on inflation, despite risks economic growth will slow, "suggests that the market should not expect a dramatic shift in Fed thinking without a dramatic shift in the economic data," Lehman Brothers economist Drew Matus said in a note to clients.

There's been a lot of talk about the possibility of a rate cut. However, the Fed's own statements have been incredibly consistent. They have consistently stated inflation is their primary concern. Every public statement dealing with the economy has had a paragraph about inflation which has universally had the sentiment, "inflation remains elevated and that makes us really unhappy."

I get a bit perturbed at the entire class of Fed prognosticators who read waaaaayyyyyy too much into the Fed statement. I think some of these people need to go back and take a remedial reading course.

St. Louis Fed's Poole On Inflation

From Bloomberg:

St. Louis Federal Reserve Bank President William Poole said he would have a ``high hurdle'' for favoring interest-rate cuts if inflation stays near the current pace.

``There would have to be a high hurdle for me to want to be cutting rates if the economy is only marginally and tentatively on the weak side'' and inflation isn't slowing toward 2 percent, Poole said after a speech in New York today.

Poole's comments on inflation differed from the text of his remarks distributed to reporters by the St. Louis Fed beforehand. In that version, Poole said ``inflation is retreating as energy prices stabilize.'' The St. Louis Fed chief told reporters later that that was a previous draft.

My guess is there is some back door political maneuvering going on. Last week, Bernanke clarified the Fed's policy in his Congressional testimony. Bernanke once again focused on inflation. Now Ben wants the Fed to be consistent in its policy orientation.

Reading between the lines, one has to wonder why the speech's text wasn't altered.

Bernanke on Housing

From his Congressional Statement:

The principal source of the slowdown in economic growth that began last spring has been the substantial correction in the housing market. Following an extended boom in housing, the demand for homes began to weaken in mid-2005. By the middle of 2006, sales of both new and existing homes had fallen about 15 percent below their peak levels. Homebuilders responded to the fall in demand by sharply curtailing construction. Even so, the inventory of unsold homes has risen to levels well above recent historical norms. Because of the decline in housing demand, the pace of house-price appreciation has slowed markedly, with some markets experiencing outright price declines.

The near-term prospects for the housing market remain uncertain. Sales of new and existing homes were about flat, on balance, during the second half of last year. So far this year, sales of existing homes have held up, as have other indicators of demand such as mortgage applications for home purchase, and mortgage rates remain relatively low. However, sales of new homes have fallen, and continuing declines in starts have not yet led to meaningful reductions in the inventory of homes for sale. Even if the demand for housing falls no further, weakness in residential construction is likely to remain a drag on economic growth for a time as homebuilders try to reduce their inventories of unsold homes to more normal levels.

Translation:

1.) Housing is the main reason why US GDP growth dropped about 2% points over the last three quarters.

2.) There are a ton of homes on the market.

3.) If demand levels remain at these levels and don't fall any further, it's going to take a long time to clear available inventory.

Therefore:

4.) Housing will remain a drag on the economy for longer than we would like.

And on top of that, inflation isn't behaving. Right now it really sucks being head of the Federal Reserve.

Bernanke's Opening Statement, pt. I Inflation

Here is the link to his complete testimony

Let me now turn to the inflation situation. Overall consumer price inflation has come down since last year, primarily as a result of the deceleration of consumers� energy costs. The consumer price index (CPI) increased 2.4 percent over the twelve months ending in February, down from 3.6 percent a year earlier. Core inflation slowed modestly in the second half of last year, but recent readings have been somewhat elevated and the level of core inflation remains uncomfortably high. For example, core CPI inflation over the twelve months ending in February was 2.7 percent, up from 2.1 percent a year earlier. Another measure of core inflation that we monitor closely, based on the price index for personal consumption expenditures excluding food and energy, shows a similar pattern.

Translation: Inflation came down for awhile. But it's increased over the last few months, and we don't like that too much. It makes our job a whole lot harder.

Core inflation, which is a better measure of the underlying inflation trend than overall inflation, seems likely to moderate gradually over time. Despite recent increases in the price of crude oil, energy prices are below last year�s peak. If energy prices remain near current levels, greater stability in the costs of producing non-energy goods and services will reduce pressure on core inflation over time. Of course, the prices of oil and other commodities are very difficult to predict, and they remain a source of considerable uncertainty in the inflation outlook.

Translation: We've been saying inflation would moderate for awhile and it hasn't.

Also -- Ben might want to take a look at this chart of gas prices, which indicates they're higher now than this time last year.



I also think it's interesting he did not mention anything about agricultural prices, which have been increasing for the last few years and have started to increase over the last 3 months in the PPI and CPI report.

Although core inflation seems likely to moderate gradually over time, the risks to this forecast are to the upside. In particular, upward pressure on inflation could materialize if final demand were to exceed the underlying productive capacity of the economy for a sustained period. The rate of resource utilization is high, as can be seen most clearly in the tightness of the labor market. Indeed, anecdotal reports suggest that businesses are having difficulty recruiting well-qualified workers in a range of occupations. Measures of labor compensation, though still growing at a moderate pace, have shown some signs of acceleration over the past year, likely in part the result of tight labor market conditions.

Translation: We still think inflation is more likely to increase than decrease. So much for my statement at the beginning that "we expect inflation pressures to moderate".

Short version: The Fed is still focused on raising rates if inflation increases.

OPEC Production Cuts Reduce Output By 1 Million Barrels/Day

From Bloomberg:

Saudi Arabia is shipping less oil to customers. OPEC by February reduced daily output by 1 million barrels. Global inventories this year fell the most in a decade.

Credit Ali al-Naimi, oil minister of Saudi Arabia, the world's largest exporter, who told OPEC members that production cuts would stop a six-month decline in oil. Crude this year rebounded 26 percent from a 20-month low to $62.81 a barrel.

``We are happy with the level of compliance,'' Mohamed al- Hamli, president of the Organization of Petroleum Exporting Countries, said in an interview in Bangkok on March 22.

Oil has bounced around between roughly $57 - $62/barrel for the last few months. OPEC's production cuts should help to provide a floor for prices going forward.

The decline in inventories is also providing a floor for oil prices.

This is not good news for the Federal Reserve who are caught between stubbornly persistent inflationary pressures (in part caused by commodity prices) and slower growth.

The Fed is Caught Between A Rock and A Hard Place

From the AP:

"The Fed is caught right now. The inflation numbers are looking worse, but on the other hand, the economy is looking softer," said David Wyss, chief economist at Standard & Poor's in New York.

Wyss said he believed the Fed was using the statement to edge closer to cutting rates if necessary to bolster economic growth, but he said investors should not expect any change at the Fed's next meeting on May 9.

David Jones, chief economist at DMJ Advisors, a private consulting firm, said he believed the Fed would remain on hold probably until September.

"The Fed is facing a standoff. The economy is slowing and inflation is getting worse," Jones said. "They have got to let the dust settle on this very mixed picture before they do anything."

Wyss said the Fed could cut rates as many as three times although he said some of those reductions might not come until next year.

Jones said he believed the Fed might be content to just cut rates once in the second half of this year if the economy is showing signs of rebounding at that time.

Let's look at the overall numbers.

GDP growth has been "below full potential". It grew at a pace of 2%, 2.6% and 2.2% in the second - fourth quarter of 2006, respectively. Housing has the big reason as it decreased 11%, 19% and 19% in the same quarters.

At the same time, inflation has increased. Here's a year-over-year chart of core CPI:



Yesterday the markets were just thrilled about the possibility of a rate cut. But they forgot about inflation. Assuming all things remain the same, the Fed won't be lowering rates anytime soon.

Right now it sucks to be a Central Banker.