Readers may recall that Duy provided a great analysis prior to the Fed’s last FOMC meeting, and concluded the Fed shouldn’t cut, which he took to mead the Fed wouldn’t cut. Now having learned how fearful the Fed is of ruffling the market, Duy gives an excellent recounting of the Fed’s new tough anti-further-rate-cuts party line. He focuses on the disconnect between the Fed’s stance and the market’s expectations (Fed fund futures have been consistently pricing in a 80+% probability of a 25 basis point cut in December) and concludes the Fed will fold.
Anyone interested in the Fed is strongly encouraged to read his entire post. Although Duy’s analysis is first rate, there is one subtlety he misses. He sees the conflict as “Fed doesn’t see sufficient grounds for a cut, while market participants see markets as so fragile that if the Fed doesn’t deliver a cut, they will fall apart.”
There are a couple of other possible justiifications for the difference in the Fed’s versus the faceless “market’s” perspective. One is the one implied in Duy’s headline, the game of chicken. It may be that the Fed fund traders have concluded they can bully the Fed. If they price in a 25 basis point increase, the Fed is too cowed, given the turmoil back in August and September, to deny it to them.
The second is that the Fed and the credit market participants have different forecasts of the likely extent of credit losses. I have noted repeatedly that Bernanke has been using estimates of subprime losses that are at the rock bottom end of the prevailing ranges. For instance, early in the summer, he said he expected them to come in at $50 billion. At that point, no reputable private sector source had an estimate of under $100 billion. Similarly, my recollection (and forgive me for not tracking down the date, but it was after August) of Bernanke’s last public remarks that contained an estimate of subprime losses put it at $100 billion. Again, it was considerably below prevailing estimates.
So the disparity may be that the Fed really doesn’t accept that the credit losses are going to be as bad as most market participants expect them to be. Thus, they expect more cuts because they know the banking system will need a steep yield curve to rebuild its balance sheet.
In other words, the Fed somehow seems to be failing to connect the dots: the credit markets are fragile because they see a lot more losses in the pipeline. The Fed appears not to recognize that fact. If they did, you would expect to see a lot more communication with the ECB and the Bank of England about what to do if things were to unravel, or whether any measures could be taken to improve conditions in sure-to-be troubled products, like collateralized debt obligations.
Financial market participants are staking out a position that appears completely at odds with the intentions of policymakers. The Fed’s repeated decisions to throw stated inflation worries overboard in the face of the ongoing mortgage/housing/credit market turmoil – even as they reiterate their medium term forecast – has engendered expectations they will continue to cut rates until market conditions normalize and the housing market clearly bottoms out. Neither one of those things is likely to happen before December 11.
In other words, the Fed’s inability to communicate the nuances of their “risk management” paradigm has cost them credibility with financial market participants. The Fed is saying they expect weak growth, it needs to be exceptionally weak to get us to cut. Market participants are saying “you cut rates when GDP growth was nearly 4% and the economy added 166k jobs. How could we possibly believe that you will pause when GDP growth is 1% and job growth is closer to 80k?”
I am hard pressed to see a pattern of data evolve between now and December 11 that would suggest growth is significantly lower than the 1-1.5% range the Fed appears to anticipate. There is just not that much data between now and then. Combine that outlook with the consistent Fed rhetoric almost explicitly saying they intend to pause and a “no cut” call should be a slam dunk. But market participants are effectively saying that ongoing credit turmoil argues for continued risk management cuts, and if the Fed doesn’t deliver, already fragile markets will become unglued. Thus, by this thinking, the Fed will have to deliver a cut. And that is a cut the Fed has been delivering since September – August if you include the surprise discount rate cut.
The smart money has been to bet on the market. I simply am not confident that this Fed is willing hold off on a rate cut simply to establish credibility. If Fed officials want to shift expectations away from a rate cut, they need to stop talking about the “risk management” approach. Just give the forecast, stop giving reasons to ignore the forecast.
As an aside, if you are looking for political motivations for the Fed to keep cutting, doesn’t it seem like just a little too coincidental that on the day Krozner makes a clearly hawkish speech that Senator Dodd threatened to hold up Krozner’s Senate confirmation? Apparently, if Krozner wants to keep his job, he better be voting for a cut next month, regardless of his Friday speech?
Bottom Line: Anyone taking Fed comments at face value can reasonably conclude that the intention of policymakers is to pause in December. I don’t know how you can get any more blunt than Krosner on this point. They are looking for data significantly at odds with their forecast to justify another cut, but there is not that much data coming in over the next few weeks. Yet I still shade my expectations toward another rate cut, as I can’t see the Fed willing to risk market stability to cement their credibility. It’s all risk management…