June 30, 2006
WATCH THAT DATA
Yesterday's 25-basis-point hike in the Fed funds rate--the 17th in a row--managed to surprise no one. But the accompanying FOMC statement was anything but routine this time around.
The central bank opted to keep the markets guessing a bit more with its latest prose. Let's call it the high art of espousing neutrality with a touch more gusto. David Resler, chief economist at Nomura Securities in New York, yesterday wrote in a note to clients that the FOMC statement "suggests more strongly than in those of the past that the future course of policy is now wholly data dependent." In other words, anything's possible, depending on the number du jour.
In any case, the threat of inflation is now firmly embedded in Fed thinking, as per the FOMC's advisory: "Readings on core inflation have been elevated in recent months." As a result, the notion that 25-basis-point hikes will now arrive like clockwork at each and every FOMC meeting has all but passed into history. In its wake is something different, which is to say that the Federal Reserve is more likely to surprise Mr. Market in the future than at any time since the central bank began elevating the price of money back in June 2004. Granted, if the data permits, the Fed may take a pass on another rate hike. But if the surprises go the other way, something tougher may come in terms of responses, and perhaps faster than you think.
One economist we talked with thinks Bernanke and company believe it's time to take off the kid gloves with the fixed-income set. In fact, the Fed is now prepared to adjust monetary policy to a degree and on a timetable that isn't necessarily obvious to the bond traders who've come to anticipate only modesty and predictability from the central bank. So says Robert Dieli, president and founder of the economic consultancy RDLB Inc., a Lombard, Ill. shop that also runs Mr. Model, an economics web site. More to the point, Diele tells CS that the Fed, if it feels obliged, may hike rates by more than 25-basis-points, and perhaps on a day other than the regularly scheduled FOMC huddle.
"If we get a bad consumer price index report, for instance, the Fed might do something the next day," Diele muses.
What convinces this 23-year veteran of dispatching economic forecasts that surprises may be the new new thing in monetary fashion this season? The data, in short, speaks to him, as he outlined in a report he penned last week titled Mr. Bernanke's Dilemma. In the essay, Diele advises that the Fed's hard-won respect on fighting inflation took the better part of a generation to acquire. It could be lost much quicker. Ideally, the state of monetary nirvana that characterizes the past decade or two comes when the Fed funds rate is sandwiched between the yield on long Treasuries above and core inflation, defined by the Personal Consumption Expenditures Index, excluding food and energy, below. No easy task, as the central bankers in the 1970s and early 1980s learned--the hard way.
Alas, this "comfort zone" that some thought had become the natural order of the universe is now in danger of evaporating, at least for the foreseeable future. The core PCE, in other words, appears intent on moving out and above this zone, as illustrated by a chart borrowed from Diele's report, reprinted below.
Source: Robert Dieli, www.mrmodelonline.com
The dilemma is that raising Fed funds, so as to coax core PCE lower in the months and years ahead, risks inverting the yield curve, which historically has been associated with subsequent recessions. Indeed, Fed funds are now at 5.25%--slightly above the 10-year Treasury's yield and equivalent to the 30-year's, as of last night's close.
The challenge of maximizing employment and minimizing inflation isn't new when it comes to thankless tasks that await the Fed. But neither is the job getting any easier. Much of Bernanke's success (or failure) will likely draw on his ability (inability) to convince the markets that he's the right man at the right time. But civility and manners aren't Wall Street's forte, and so the default reaction is one of casting more than a little doubt on the new man at the helm.
Yes, Wall Street's a tough crowd…usually. But it's always been so for newly minted Fed chiefs, Diele reminds. Even Paul Volcker, who had perhaps the most respect of any incoming Fed head in recent history, had to earn his stripes the hard way: by showing results. To be sure, history now judges him as one of the greats in central banking because he ultimately delivered the goods in the early 1980s. But in the beginning, the Street wasn't inclined to cut him any slack.
No less awaits Bernanke, who's already had more than his share of missteps in transitioning from academia to running the world's most powerful bank. But the window for forgiveness is closing, and at the moment actions speak louder than words (or one-on-one interviews with TV journalists at Washington parties).
Bernanke must convince the bond market that it needs to do more of the heavy lifting in nipping any inflationary momentum in the bud, Diele says. The baby-step approach of 25-basis-point hikes stretched out over time hasn't done the trick. Time now for something bolder, he counsels, assuming the incoming information implies as much. And don't even think about helicopters.
Posted by jp at June 30, 2006 6:48 AM