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Tim Duy Weighs in on What the Fed Might Do Next

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Tim Duy, economics professor at the University of Oregon, posts from time to time on Mark Thoma’s blog, Economist’s View, and Fed watching is one of his favorite topics. His latest, “The Fed’s Next Move,” is particularly thorough and cogent.

He goes through the case for further rate cuts and finds the consensus view, that more reductions are in the offing, to be well founded. He believes that the Fed “is no longer confident it can disentangle housing from financial markets” and therefore will give the housing market considerable weight in its decisions. He then argues that this posture is futile, since cuts won’t restore the bubble mentality of faith in ever-rising prices. But deteriorating housing and falling inflation (if you believe those “core” CPI and PPI stats) give a thumb’s up to further cuts. He then goes through the caveats (he doesn’t buy the view that inflation is tame, but he also discounts hawkish statements by Fed bank presidents).

The foregoing is all very much worth reading in long form, but here is the doozy:

For my part, I am concerned that the Fed appears to have written off the dollar. My concern stems from rising international tensions – the Fed is dumping additional liquidity into the system at a time when most central banks are attempting to turn off the faucet. The Fed is implicitly, if not explicitly, relying on countries with fixed exchange rates to absorb that additional liquidity at the cost of inflation in those economies. Moreover, those economies with floating rates become the anti-Dollar bets, forcing the Euro area, Canada, the UK, etc, to be the deflationary counterweights to the inflationary US policy.

Is it a surprise that the ECB is under pressure to support the Euro with a rate cut? The only surprise is that there is not more chatter about an ECB intervention if only to erase the idea buying the Euro is a one way bet.

In my darker moments, I fear that the Fed is forcing their foreign counterparts down one of two paths – either central banks with appreciating currencies throw in the towel and match Fed rate cuts, thereby unleashing a fresh wave of global liquidity, or central banks with fixed exchange rate finally decide that they can no longer bear the inflationary cost of supporting the US current account deficit.

Adding to my concerns is that the Fed is overestimating the downside risk to the economy. Certainly, the past correlation between housing downturns and recessions is nothing to ignore. But too many indicators are not consistent with a recession for me to be embrace a dark outlook. Why are initial unemployment claims flat? Why does the consumer appear to have momentum in the 3Q07? Why are readings on manufacturing activity not solidly on the decline? Why did the inventory to sales ratio slide back to its lows? Why does the Baltic Dry Index continue to reach new highs? Why isn’t faltering demand undercutting support for oil prices?

Bottom Line: The housing down / inflation down data flow gives the Fed room to continue cutting on the basis of forecast uncertainty. Presumably, strong data would undermine the case for additional cuts, leaving me wary of blow out ISM and employment reports. There is a risk that the Fed did intend the September move to be a “one and done” action, but unless they want to get into the habit of surprising financial markets, they need to make that clear – or the data need to be strong enough to do it for them.

I think the reason that the economic figures still look solid is 1) some of them do not correspond with reality (per Duy’s discussion of inflation earlier in his post) and 2) consumer spending is up in part due to inflation rather than unit growth, and in part due to reluctance to curtail their lifestyle. Spending will hold up only as long as they have access to credit. As the home equity lines begin to be tapped out, or consumer confidence takes more of a beating (which will reduce their inclination to borrow), you will see the slowdown take hold.

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5 comments

  1. periodista miguel

    As always, you provide good analysis. And in this case, a nice counterpoint to Prof. Duy (who is also very good).

    Is there statistical basis for saying consumer spending growth is a matter of inflation? I take it you are basing that on volume sales numbers…

    And as to the validity of the data itself, if you read Barry (‘Inflation Ex-Inflation’) Ritholtz, you know some people are verrry agitated on at least one component of the question. I have been waiting for the job claims to add to the slowing economy case. But no. (A conundrum? Or will be just seem them cruise along in the 300K range until suddenly they are at 400,000…?)

    Will be interesting to see what the payroll numbers say Friday.

    Thanks again for the good work –

  2. Yves Smith

    periodista miguel,

    My usually good memory may be failing me, but I recall one post by Barry Ritholtz not all that long ago which talked about the impact of both gas and food inflation on reported consumer spending. I found this post, which talked about gas, but haven’t located the one that was broader in focus:

    http://bigpicture.typepad.com/comments/2007/05/commerce_retail.html

    A related but not conclusive post:

    http://bigpicture.typepad.com/comments/2007/07/retail-day.html

    Google doesn’t let you organize results by date, which is making this very inefficient…

  3. Periodista Miguel

    I can’t do any better than you at culling Barry’s posts, but that has been one of his repeating memes: that the Fed conveniently eliminates all inflation from their measure of inflation. And it’s no problem if you don’t drive, don’t heat your home and don’t eat….(!!)

  4. Anonymous

    ” For my part, I am concerned that the Fed appears to have written off the dollar. My concern stems from rising international tensions – the Fed is dumping additional liquidity into the system at a time when most central banks are attempting to turn off the faucet. The Fed is implicitly, if not explicitly, relying on countries with fixed exchange rates to absorb that additional liquidity at the cost of inflation in those economies. Moreover, those economies with floating rates become the anti-Dollar bets, forcing the Euro area, Canada, the UK, etc, to be the deflationary counterweights to the inflationary US policy.”

    This fellow is the leading fed watcher in the blogosphere? Yet he doesn’t understand that a Fed rate cut doesn’t “dump liquidity” into the system. That’s only been true with the extraordinary discount window actions, but has nothing to do with normal or abnormal funds policy. Surprising how many of these experts don’t understand how the Fed balance sheet works in practice.

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