Baum: Fed’s Hawkishness Overrated

A solid column from Bloomberg’s Caroline Baum on what she sees as the market’s irrational expectations for the Fed. Key points:

Investors focused on Bernanke’s remarks about inflation and the dollar, when he also stressed the less than robust growth outlook

The last time the central banks said it saw inflationary risks predominating it wound up cutting rates instead

Given the lack of any engine of growth in the economy, the strongest action likely is a “cosmetic” 25 basis point increase

From Baum:

One week ago, the likelihood that the Federal Reserve would raise its benchmark interest rate at the Aug. 5 meeting was zero, according to fed funds futures prices. Yesterday, the odds were better than 65 percent….

The sell-off was aided and abetted by real or perceived hawkish comments from Federal Reserve Chairman Ben Bernanke.

“Inflation has remained high,” Bernanke told the attendees at the Boston Fed’s 52nd annual economic conference in Chatham, Massachusetts, on June 9 in a statement of the obvious.

So far, there’s been only limited pass-through from soaring raw materials costs to consumer prices and wages, a result of soft domestic demand, he said. “The continuation of this pattern is not guaranteed.”

To ensure that it continues, the Fed will “strongly resist an erosion of longer-term inflation expectations.”

This followed by a week Bernanke’s groundbreaking comment that the weak dollar had implications for inflation and inflation expectations.

Of course, he also told the Boston Fed conference that “growth risks remain to the downside,” but no one seemed to be listening.

And those risks are still there, which is why, hawkish talk notwithstanding, the Fed isn’t about to rock the still shaky boat.

“They are not about to do a multistep tightening,” said Paul Kasriel, chief economist at Northern Trust Corp. in Chicago. “If they did, it would be aborted very quickly.”

Kasriel doesn’t discount the possibility of a little cosmetic tightening. “It’s conceivable they could show their inflation-fighting credentials and bump the funds rate up 25 basis points in August,” he said. “But I don’t think they will.”

Yesterday’s retail sales for May showed surprising strength, rising 1 percent. That changes the arithmetic of second-quarter gross domestic product. It doesn’t change the fundamentals driving the economy.

Housing prices are falling.

The unemployment rate is rising.

Non-residential investment is slowing.

Business confidence is slumping.

The U.S. auto industry is dead.

State and local governments are cutting back.

Bank credit has been falling since March.

The Fed’s monetary base is barely growing in nominal terms.

“There’s no there there” for a second-half recovery, said Bob Barbera, chief economist at ITG Inc., a New York brokerage, who expects “an extended period of below-trend growth.”….

Economists at Goldman Sachs Group Inc. are also resisting the rising tide of expectations of higher interest rates. The reasons, as chief economist Jan Hatzius outlines in a recent commentary, are: increased slack in the economy, with rising unemployment curbing whatever impetus there might be for higher wages; data on inflation and inflation expectations that have been “mixed rather than downright awful”; and a dollar that has been stable on a trade-weighted basis since late February.

What’s more, “prior sell-offs at the front end of the yield curve have sometimes proven to be poor predictors of policy,” Hatzius said.

Not to mention what the Fed says. It was only last August that policy makers viewed the risks to the economy as weighted toward higher inflation. One month later, the Fed cut the interbank rate by 50 basis points, followed by another 275 basis points in the next seven months.

So what to make of the recent rhetoric from Bernanke and other members of the policy committee?

“I think the Fed is uncomfortable with the funds rate below the inflation rate,” Kasriel said.

As well they should be. The economic consequences of a negative real funds rate are pretty clear. With central bankers around the globe aware of the cost of restraining inflation and their own credibility once the genie is out of the bottle, you can’t blame them for talking tough.

The question is, can they or will they follow through? The Fed is independent, yes; it’s not immune to political realities. After facilitating and financing the purchase of Bear Stearns Cos. by JPMorgan Chase & Co. in March, how would members of Congress react to a rate increase at a time when their constituents are struggling to buy food and gas for their families?

Bernanke is certain to be reminded of the Fed’s dual mandate — maximum sustainable employment and price stability — when he testifies before the Senate Banking and House Financial Services committees in July.

Maybe that’s why, as Kasriel’s Northern Trust colleague, Asha Bangalore, points out, the Fed has never raised the federal funds rate until after the unemployment rate starts falling.

The Fed is in no position to raise interest rates. The U.S. economy is in or close to recession. Americans are losing their jobs, their homes, their wealth and their confidence.

Policy makers stress the importance of anchoring inflation expectations. They probably would be willing to tolerate a little drift when the alternative is sinking the ship.

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  1. Jojo

    Perhaps the reason the FED is perceived as “hawkish” is because Bernacke is using REAL numbers internally, not the massaged pap that the government and media always tout? If so, then there is considerable reason for the FED to be worried!


    Meanwhile, Congress continues to fiddle as Rome burns. In the latest example, legislation to extend unemployment benefits keeps being kicked around the Senate and the House like a hot potato. Republican governor Schwarzenegger of Calif. has called for passage of an extension back in April and John McCain has said he would vote for such an extension. But of course, always blue-sky Bush has threatened to veto any such bill containing an extension, saying it isn’t needed. And the 142 NO votes to the latest legislation in the House all came from Republicans. Remember this fact voters, come November.

  2. SunnyD

    The Fed is in no position to raise interest rates. The U.S. economy is in or close to recession. Americans are losing their jobs, their homes, their wealth and their confidence.

    By no means am I a technical analyst, but just a casual observer. So we has a recession at the beginning of the 1990’s. We got of that recession with capital investment from the digital revolution. We then went to a recession with the bust, and then subsequently post-9/11 stupor. Then, we went moved to the housing boom, with capital investment coming – from where exactly? A big pyramid scheme, that generated current “wealth” with the anticipation of a future buyer. So now, we have an entire swath of businesses that are basically coming to a crash as the home ATM is coming dry. So, now we’re realizing that hundreds of buildings of dollars of “wealth” has evaporated; unfortunately, the Fed is trying to monetize this debt.

    So the question is: what exactly are we trying to stimulate? While retail sales were up 1%, it was on the basis of dubious inflationary numbers. The days of the McMansions, the Hummers, and the $5 lattes are gone.

    In my humble opinion, we’re better off with fiscal policy targeting key sectors (e.g. agricultural exports, renewable energy), either through direct investment or tax credits, that would provide jobs as well as (hopefully) correcting the twin deficits.

  3. Richard Kline

    The Fed raising by 25 bips is neither more nor less ‘cosmetic’ for the financial system; the key is that it tells be money boys whether to bet on red or black. That is not a small difference. Of course us folks our in Realityville haven’t seen too much out of those 300 bips the Fed has leaked; they didn’t pass through to most of what we’re borrowing—cause the top tier banks done et it all. And who, now, are those arguing loudly that the Fed “can’t raise,” and even if it did the move would “only be cosmetic?” Those same top tier money boys. Yup.

    Look, the issues with rates up concern disastrously negative rates, out of control speculation, a fragile currency, and terrible exported inflation to dollar pegger. But all the Fed is _allowed_ to talk about is domestic US inflation, so that’s what they are talking about. But if anyone takes that as the issue, and tries to build a case for or against THAT issue, they are only fooling themselves: that is not the issue. The Fed needs to start raising rates if at all possible, even in baby steps, though not fast. And they and their overseas creditors know it.

    When the Fed said last August that they might need to raise rates, they were absolutely correct. Their mistake was to cut too much too fast. At the behest of the big money boys. We need to excuse some of those plutocrats from further attendance in the lifeboat. To hear them sqwaking not says that the Fed has found the right target on inflation, methinks.

  4. S

    The fed is toothless and has been for quite some time. There was a fascinating story after yesterday’s close that an unknown governement official is rumored to be concerned that the cds for lehman was tightenng as the stovck was selling off this week. In other words the fed official is worried that the markets are pricing in a no one fails situation. Everytime the font end sells off is a time to buy. Look at what is happening to Comerica, fifth third, Key, Wachovia..these banks can not afford a flattening curve or rising front end. NIM compression spells diaster for the banks, the sole beneficiary of the fed cutting regime. The Fed is not going to reverse this unless Trichetdrags it by its neck kicking and screaming to protect the rate differentials. The FT article this morning talking about wages being up 3+ percentin Europe YTD and the prospects of embedded expectations. It would be more productive to watch what the Chinese are saying about treasuries and the Foreign Central Banks are doing tha to focus on the FEd. The Fed is talking tough becuase it is being forced to by the ECB and others. A 35 bps raise is insulting and yet the perma bulls cheer it hoping that the suckers will buy it as resolve. The US has really become a paper tiger.

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