Category Archives: Fed

Trade numbers

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U.S. Trade Deficit Hits 14-Month High on Oil Imports

by Reed Saxon

The U.S. trade deficit in November surged to the highest level in 14 months, reflecting record imports of foreign oil. The deficit with China declined slightly while the weak dollar boosted exports to another record high.

The Commerce Department reported that the trade deficit, the gap between imports and exports, jumped by 9.3 percent, to $63.1 billion. The imbalance was much larger than the $60 billion that had been expected.

The increase was driven by a 16.3 percent surge in America’s foreign oil bill, which climbed to an all-time high of $34.4 billion as the per barrel price of imported crude reached new records. With oil prices last week touching $100 per barrel, analysts are forecasting higher oil bills in future months.

The big surge in oil pushed total imports of goods and services up by 3 percent to a record $205.4 billion. Exports also set another record, rising by a smaller 0.4 percent to $142.3 billion. Export demand has been growing significantly over the past two years as U.S. manufacturers and farmers have gotten a boost from a weaker dollar against many other currencies. That makes U.S. goods cheaper on overseas markets.

Exports still moving up.

Through the first 11 months of 2007, the deficit is running at an annual rate of $709.1 billion, down 6.5 percent from last year’s all-time high of $758.5 billion. Analysts believe that the export boom will finally result in a drop in the trade deficit in 2007 after it set consecutive records for five years.

Agreed. Ultimately, the only way the foreign sector can slow their accumulation of $US, as the falling $ indicates they are in the process of doing, is to spend it here.

The growth in exports has been a major factor cushioning the blow to the economy from the slump in housing and a severe credit crunch. However, with oil pushing imports up sharply, analysts believe the help from trade in the final three months of last year will be shown to have been significantly smaller.

Could be. December numbers will not be out for another month.

By country, the deficit with Canada, America’s largest trading partner, dropped by 12.1 percent to $4.7 billion in November while the imbalance with Mexico rose by 1.4 percent to $7.6 billion. The imbalance with the European Union fell by 12.6 percent to $10.4 billion.

Might explain some weakness in Canada and Eurozone.

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Re: Bernanke

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(email)

On 11 Jan 2008 11:17:34 +0000, Prof. P. Arestis wrote:
>   Dear Warren,
>
>   Many thanks. Some good comments below.
>
>   The paragraph that I think is of some importance is this:
>
> >  The Committee will, of course, be carefully evaluating incoming
> >  information bearing on the economic outlook. Based on that evaluation,
> >  and consistent with our dual mandate, we stand ready to take
> >  substantive additional action as needed to support growth and to
> >  provide adequate insurance against downside risks.
>
>   If I am not wrong this is the first time for Bernanke that the word
>   inflation does not appear explicitly in his relevant statement. But also
>   there is no mention of anything relevant that might capture their motto
>   that winning the battle against inflation is both necessary and sufficient
>   for their dual mandate.
>
>   Are the economic beliefs of BB changing, I wonder? I rather doubt it but
>   see what you think.

Dear Philip,

I see this is all part of the Bernanke conumdrum.

Implied is that their forecasts call for falling inflation and well anchored expectations, which can only mean continued modest wage increases.

They believe inflation expectations operate through two channels-accelerated purchases and wage demands.

Their forecasts use futures prices of non perishable commodities including food and energy. They don’t seem to realize the
‘backwardation’ term structure of futures prices (spot prices higher than forward prices) is how futures markets express shortages.

Instead, the Fed models use the futures prices as forecasts of where prices will be in the future.

So a term structure for the primary components of CPI that is screaming ‘shortage’ is being read for purposes of monetary policy as a deflation forecast.

Bernanke also fears convertible currency/fixed fx implosions which are far more severe than non convertible currency/floating fx slumps. Even in Japan, for example, there was never a credit supply side constraint – credit worthy borrowers were always able to borrow (and at very low rates) in spite of a near total systemic bank failure. And the payments system continued to function. Contrast that with the collapse in Argentina, Russia, Mexico, and the US in the 30’s which were under fixed fx and gold standard regimes.

It’s like someone with a diesel engine worrying about the fuel blowing up. It can’t. Gasoline explodes, diesel doesn’t. But someone who’s studied automobile explosions when fuel tanks ruptured in collisions, and doesn’t understand the fundamental difference, might be unduly worried about an explosion with his diesel car.

More losses today, but none that directly diminish aggregate demand or alter the supply side availability of credit.

And while the world does seem to be slowing down some, as expected, the call on Saudi oil continues at about 9 million bpd,
so the twin themes of moderating demand and rising food/fuel/import prices remains.

I also expect core CPI to continue to slowly rise for an extended period of time even if food/fuel prices stay at current levels as
these are passed through via the cost structure with a lag.

All the best,

Warren

>
>  Best wishes,
>
>  Philip

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Comments on Bernanke speech

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Although economic growth slowed in the fourth quarter of last year from the third quarter’s rapid clip, it seems nonetheless, as best we can tell, to have continued at a moderate pace.

Q4 GDP seen as ‘moderate’ – that is substantially better than initial expectations of several weeks ago.

Recently, however, incoming information has suggested that the baseline outlook for real activity in 2008 has worsened and the downside risks to growth have become more pronounced.

They initially said this for Q3 and for Q4.

Notably, the demand for housing seems to have weakened further, in part reflecting the ongoing problems in mortgage markets.

Maybe, but even if so, housing is now a much smaller influence on GDP.

In addition, a number of factors, including higher oil prices,

Yes, this slows consumer spending on other items, but oil producers have that extra income to spend, and if they continue to do so, GDP will hold up and exports will remain strong.

lower equity prices, and softening home values, seem likely to weigh on consumer spending as we move into 2008.

The fed has little if any evidence those last two things alter consumer spending.

Financial conditions continue to pose a downside risk to the outlook for growth.

Market participants still express considerable uncertainty about the appropriate valuation of complex financial assets and about the extent of additional losses that may be disclosed in the future. On the whole, despite improvements in some areas, the financial situation remains fragile, and many funding markets remain impaired. Adverse economic or financial news has the potential to increase financial strains and to lead to further constraints on the supply of credit to households and businesses.

Yes, his main concern is on the supply side of credit. With a floating fx/non convertible currency, there is a very low probability. Even Japan with all its financial sector problems was never credit constrained.

Debilitating credit supply constraints are byproducts of convertible currency/fixed fx regimes gone bad, like in the US in the 1930s, Mexico in 1994, Russia in 1998, and Argentina in 2001.

I expect that financial-market participants–and, of course, the Committee–will be paying particular attention to developments in the housing market, in part because of the potential for spillovers from housing to other sectors of the economy.

A second consequential risk to the growth outlook concerns the performance of the labor market. Last week’s report on labor-market conditions in December was disappointing, as it showed an increase of 0.3 percentage point in the unemployment rate and a decline in private payroll employment. Heretofore, the labor market has been a source of stability in the macroeconomic situation, with relatively steady gains in wage and salary income providing households the wherewithal to support moderate growth in real consumption spending. It would be a mistake to read too much into any one report.

Right, best to wait for the revisions. November was revised to a decent up number, and October was OK as well. And today’s claims numbers indicate not much changed in December.

However, should the labor market deteriorate, the risks to consumer spending would rise.

Yes, if..

Even as the outlook for real activity has weakened,

Yes, the outlook has always been weakening over the last six months, while the actual numbers subsequently come in better than expected. Seems outlooks are not proving reliable.

there have been some important developments on the inflation front. Most notably, the same increase in oil prices that may be a negative influence on growth is also lifting overall consumer prices and probably putting some upward pressure on core inflation measures as well.

Interesting that he mentions upward pressure on core – must be in their forecast. It took them a long time to get core to moderate, and even in August they did not cut as upward risks remained.

Last year, food prices also increased exceptionally rapidly by recent standards, further boosting overall consumer price inflation. Thus far, inflation expectations appear to have remained reasonably well anchored,

They have very little information on this. They only know when they become unglued, and then it is too late.

and pressures on resource utilization have diminished a bit. However, any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future.

Meaning once they go, it is too late.

Accordingly, in the months ahead we will be closely monitoring the inflation situation, particularly as regards inflation expectations.

The fed has no credibility here. Markets ignore this, and the financial press does not even report it.

Monetary policy has responded proactively to evolving conditions. As you know, the Committee cut its target for the federal funds rate by 50 basis points at its September meeting and by 25 basis points each at the October and December meetings. In total, therefore, we have brought the funds rate down by a percentage point from its level just before financial strains emerged. The Federal Reserve took these actions to help offset the restraint imposed by the tightening of credit conditions and the weakening of the housing market. However, in light of recent changes in the outlook for and the risks to growth, additional policy easing may well be necessary.

Reads a bit defensive to me.

The Committee will, of course, be carefully evaluating incoming information bearing on the economic outlook. Based on that evaluation, and consistent with our dual mandate, we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.

Financial and economic conditions can change quickly. Consequently, the Committee must remain exceptionally alert and flexible, prepared to act in a decisive and timely manner and, in particular, to counter any adverse dynamics that might threaten economic or financial stability.

This was to come out at 1PM, instead it was released at noon.

This seems they meant to send a signal that they are ready to go 50.

It may take another 0.3% core CPI number, low claims numbers, and further tightening of the FF/LIBOR spread to get them to think twice about not cutting.

Their fixed fx paradigm supply side fears elevates their perception of the downside risks.

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3 mo libor down to 4.44%

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3 mo libor is now for all practical purposes is ‘under control’ and down about 50 bp since the last Fed meeting.

Market function risk seems to be behind us, and the talk has now shifted to weakness due to softer demand.

The question is what level of demand is consistent with ‘price stability’.

In other words, to not exceed potential non inflationary GDP (the Fed’s speed limit) demand has to be low enough to not continuously drive up food/fuel/import prices.

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Plosser the hawk on the tape

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This is the most hawkish Fed pres:

GLADWYNE, PENNSYLVANIA (Thomson Financial) – The head of the Philly Fed, Charles Plosser, today raised the possibility of a stagflation threat to the US economy.

“Although I am expecting slow economic growth for several quarters, we should not rely on slow growth to reduce inflation,” the Philadelphia Federal Reserve Bank president warned in a speech here. “Indeed, the 1970s should be a sufficient reminder that slow growth and falling inflation do not necessarily go hand in hand.” Plosser, who has a vote on the rate-setting Federal Open Market Committee this year, warned that he is getting increasingly worried about inflation. “Recent data suggest that inflation is becoming more broad-based,” he said, “And recent increases do not appear to be solely related to the rise in energy prices. Consequently I see more worrisome signs of underlying price pressures.” Plosser also used today’s speech to draw a clear line between what the Fed should do to stabilize the economy and what it should do to stabilize financial markets.

He believes the Fed’s three rate cuts will take time to work through the economy and that in the meantime growth will slow.

“Since monetary policy’s effects on the economy occur with a lag, there is little monetary policy can do today to change economic activity in the first half of 2008.” In the meantime, “we will get some bad economic numbers from various sectors of the economy in the coming months,” he added.

But beyond the immediate short term, Plosser was more optimistic. He reckons the economy will “improve appreciably by the third and fourth quarters of 2008, and that is when any monetary policy action today will begin to have noticeable effects.” On the credit market front, the Fed’s new Term Auction Facility (TAF) program should help stabilize financial markets and provide liquidity when the interbank lending markets “are under stress and not functioning smoothly,” he added.

Plosser said early evidence suggests the first two 20 bln usd auctions were successful. Two more have been scheduled later this month.

The key point, he said, is that “the TAF did not change the stance of monetary policy. The Fed actually withdrew funds through open market operations as it injected term liquidity through the TAF.” Plosser was already known as one of the inflation “hawks” among the regional Fed bank presidents. His analysis confirms a preference for avoiding further rate cuts and the risk of further inflation as long as financial markets problems do not pose a danger to the rest of the economy.

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Inflation – clear and present danger?

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Food, fuel, and $/import prices present a triple negative supply shock.

Now gold pushing $900 as LIBOR falls, commercial paper issuance increases, and ‘market function risk’ subsides.

Downside risks to GDP are still not trivial.

Consumer income and desire to spend it may be problematic, and banks and other lenders may further tighten borrowing requirements.

And weaker overseas demand may cool US exports.

Yes, the Fed knows and fears demand MAY weaken, and forecasts lower inflation as a consequence.

But inflation is the clear and present danger, vs an economy that may weaken further

And mainstream economic theory says the cost of bringing down inflation once the inflation cat is out of the bag is far higher than
any near term loss of output incurred in keeping inflation low in the first place.

And the Fed addresses its dual mandate of low inflation and low unemployment with mainstream theory that concludes low inflation is a necessary condition for optimal employment and growth over the long term.

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Fed’s Lockhart: economic outlook

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He is currently leaning towards cuts, but watching carefully for signs of improvements in market functioning and output, and aware of the risks of his inflation forecast being wrong.

Fed’s Lockhart: Economic Outlook

From Atlanta Fed President Dennis P. Lockhart: The Economy in 2008

Looking to 2008, I believe the pivotal question—the central uncertainty—is the extent of current and future spillover from housing and financial markets to the general economy. The dynamics I’m watching—stated simplistically—are the following. First, there’s the effect of dropping house prices on the consumer and in turn on retail sales and other personal expenditures. And second, I’m watching the effect of financial market distress on credit availability and, in turn, on business investment, general business activity, and employment.

Yes, we are all watching that carefully. So far so good, but consumer spending is always subject to change.
I’m watching credit availability, but seems the supply side of credit is never the issue. The price changes some, but quantity is always there at ‘market’ prices that provide desired returns on equity.

Business investment seems to hold up nicely as well, probably due to most investment being for cost cutting rather than expanding output. This makes investment a type of profit center.

Employment is still increasing, more in some fields than others.

And, of course, overall, from the mainstream’s view, demand is more than enough to be driving reasonably high inflation prints.

My base case outlook sees a weak first half of 2008—but one of modest growth—with gradual improvement beginning in the year’s second half and continuing into 2009. This outcome assumes the housing situation doesn’t deteriorate more than expected

Meaning it’s expected to deteriorate some. I’m inclined to think it’s bottomed.

and financial markets stabilize.

They are assuming this and it already seems to have happened. FF/LIBOR is ‘under control.’

A sober assessment of risks must take account of the possibility of protracted financial market instability together with weakening housing prices, volatile and high energy prices, continued dollar depreciation, and elevated inflation measures following from the recent upticks we have seen.

That statement includes both deflationary and inflationary influences – not sure what to make of it.

But he will vote for 50 bp cut in January.

Maybe if the meeting were today, but much can change between now and then.

I’m troubled by the elevated level of inflation. Currently I expect that inflation will moderate in 2008 as projected declines in energy costs have their effect. But the recent upward rebound of oil prices—and the reality that they are set in an unpredictable geopolitical context—may mean my outlook is too optimistic. Nonetheless, I’m basing my working forecast on the view that inflation pressures will abate.

Doesn’t say what the Fed might do, if anything, if inflation doesn’t abate.

To a large extent, my outlook for this year’s economic performance hinges on how financial markets deal with their problems.

He believes the performance of the real economy is a function of the health of financial markets.

I’m not sure that is turning out to be the case.

The coming weeks could be telling. (What does he know). Modern financial markets are an intricate global network of informed trust. Stabilization will proceed from clearing up the information deficit and restoring well-informed trust in counterparties and confidence in the system overall.

To restore market confidence, leading financial firms, I believe, must recognize and disclose losses based on unimpeachable valuation calculations,

Maybe they already have. The penalties for not being ‘honest’ are severe, and it’s hard to see how any public company would try to cover anything like that up.

restore capital and liquidity ratios, and urgently execute the strenuous task of updating risk assessments of scores of counterparties. The good news is that markets can return to orderly functioning and financial institutions can be rehabilitated quickly. With healthy disclosure, facing up to losses, recapitalization, and the resulting clarity, I believe there is hope for this outcome.

May already be happening.

So far only about $50 billion of announced bank losses. Q4 reports will add some to that, when the majority of the remaining losses will be disclosed.

In Aug 1998 $100 billion was lost all at once with no recovery prospects, back when that was a lot of money.

So far this crisis has been mild by historical standards.

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The upcoming fiscal policy changes

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Another possibility is the Fed doesn’t want to cut rates due to inflation risks, and might see a tax cut as sufficient potential
support for demand to allow them to not cut rates and instead address the inflation issue.

This would be based on the mainstream notion (not mine) that monetary policy is for inflation, while fiscal may function to shift demand from one period to another, depending on the degree of ‘Ricardian Equivalence.’ (The mainstream presumption that agents won’t spend extra income from a tax cut as they ‘know’ there will need to be a tax hike later to keep the budget balanced.) The mainstream (again, not me) would also be concerned that the higher govt. deficit would somehow ‘crowd out’ private borrowing. Nonetheless, the Fed does have reasonably strong empirical evidence for them to believe tax cuts do support demand in the short run.

The Upcoming Fiscal Policy Changes

by NewstraderFX

(Forex Factory) There’s a growing consensus among economists that changes in Monetary policy from the Fed will not be able to do enough by themselves to prevent the economy from going into a serious downturn and that a stimulus from a change in Fiscal policy will be required. The fiscal stimulus in this case will probably take the form of a temporary tax cut.

It’s very likely that the current meetings of the Presidents Working Group on Financial markets (a.k.a. the Plunge Protection Team) have been at least in part for the purpose of discussing the ways and means of how they will work and that the actual cuts themselves will be announced during the State of the Union address. It’s also very likely that momentum for this is going to be building in market participants and that just as with a change in monetary policy, the markets themselves will trade according to the ultimate outcome of whatever happens from a fiscal perspective.

Former Clinton Treasury Secretary Lawrence Summers has been talking about this since November. In his opinion, the economy requires between 50 and 75 $Billion in temporary tax cuts. Martin Feldstein of the NBER is also suggesting that due to entrenched problems in the consumer and banking sectors, monetary policy changes will not have the same “traction” and that “some kind of fiscal stimulus” is now required. There’s a precedent here as well: Bush made a temporary tax cut during the 2001 recession so it seems fairly certain he will want to use the same tactic again. However, the implementation of a fiscal policy change will likely be more difficult from a political perspective because things are very different this time around. Back in 2001, Congress was under Republican control so passing the tax cut was relatively easy. Now that the Democrats have control of the Hill, the actual passage could be far more difficult.

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The subprime mess

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On Jan 5, 2008 9:40 PM, Steve Martyak wrote:
> http://www.autodogmatic.com/index.php/sst/2007/02/02/subprime_credit_crunch_could_trigger_col
>
>
> also….
>
> 9/4/2006
> Cover of Business Week: How Toxic Is Your Mortgage? :.
>
> The option ARM is “like the neutron bomb,” says George McCarthy, a housing
> economist at New York’s Ford Foundation. “It’s going to kill all the people
> but leave the houses standing.”
>
> Some people saw it all coming….
>

The subprime setback actually hit about 18 months ago. Investors stopped funding new loans, and would be buyers were were no longer able to buy, thereby reducing demand. Housing fell and has been down for a long time. There are signs it bottomed October/November but maybe not.

I wrote about it then as well, and have been forecasting the slowdown since I noted the fed’s financial obligations ratio was at levels in March 2006 that indicated the credit expansion had to slow as private debt would not be able to increase sufficiently to sustain former levels of GDP growth. And that the reason was the tailwind from the 2003 federal deficits was winding down. as the deficit fell below 2% of GDP, and it was no longer enough to support the credit structure.

Also, while pension funds were still adding to demand with their commodity allocations, that had stopped accelerating as well and
wouldn’t be as strong a factor.

Lastly, I noted exports should pick up some, but I didn’t think enough to sustain growth.

I underestimated export strength, and while GDP hasn’t been stellar as before, it’s been a bit higher than i expected as exports boomed.

That was my first ‘major theme’ – slowing demand.

The second major theme was rising prices – Saudis acting the swing producer and setting price. This was interrupted when Goldman changed their commodity index in aug 06 triggering a massive liquidation as pension funds rebalanced, and oil prices fell from near 80 to about 50, pushed down a second time at year end by Goldman (and AIG as well this time) doing it again. As the liquidation subsided the Saudis were again in control and prices have marched up ever since, and with Putin gaining control of Russian pricing we now have to ‘price setters’ who can act a swing producers and simply set price at any level they want as long as net demand holds up. So far demand has been more than holding up, so it doesn’t seem we are anywhere near the limits of how high they can hike prices.

Saudi production for December should be out tomorrow. It indicates how much demand there is at current prices. If it’s up that means they have lots of room to hike prices further. Only if their production falls are they in danger of losing control on the downside. And I estimate it would have to fall below 7 million bpd for that to happen. It has been running closer to 9 million.

What I have missed is the fed’s response to all this.

I thought the inflation trend would keep them from cutting, as they had previously been strict adherents to the notion that price
stability is a necessary condition for optimal employment and growth.

This is how they fulfilled their ‘dual mandate’ of full employment and price stability, as dictated by ‘law’ and as per their regular reports to congress.

The theory is that if the fed acts to keep inflation low and stable markets will function to optimize employment and growth, and keep long term interest rates low.

What happened back in September is they became preoccupied with ‘market functioning’ which they see as a necessary condition for low inflation to be translated into optimal employment and growth.

What was revealed was the FOMC’s lack of understanding of not only market functioning outside of the fed, but a lack of understanding of their own monetary operations, reserve accounting, and the operation of their member bank interbank markets and pricing mechanisms.

In short, the Fed still isn’t fully aware that ‘it’s about price (interest rates), not quantity (‘money supply, whatever that may be)’.

(Note they are still limiting the size of the TAF operation using an auction methodology rather than simply setting a yield and letting quantity float)

The first clue to this knowledge shortfall was the 2003 change to put the discount rate higher than the fed funds rate, and make the discount rate a ‘penalty rate.’ This made no sense at all, as i wrote back then.

The discount rate is not and can not be a source of ‘market discipline’ and all the change did was create an ‘unstable equilibrium’ condition in the fed funds market. (They can’t keep the system ‘net borrowed’ as before) it all works fine during ‘normal’ periods but when the tree is shaken the NY Fed has it’s hands full keeping the funds rate on target, as we’ve seen for the last 6 months
or so.

While much of this FOMC wasn’t around in 2002-2003, several members were.

Back to September 2007. The FOMC was concerned enough about ‘market functioning’ to act, They saw credit spreads widening, and in particular the fed funds/libor spread was troubling as it indicated their own member banks were pricing each other’s risk at higher levels than the FOMC wanted. If they had a clear, working knowledge of monetary ops and reserve accounting, they would have recognized that either the discount window could be ‘opened’ by cutting the rate to the fed funds rate, removing the ‘stigma’ of using it, and expanding the eligible collateral. (Alternatively, the current TAF is functionally the same thing, and could have been implemented in September as well.)

Instead, they cut the fed funds rate 50 bp, and left the discount rate above it, along with the stigma. and this did little or nothing for the FF/LIBOR spread and for market functioning in general.

This was followed by two more 25 cuts and libor was still trading at 9% over year end until they finally came up with the TAF which immediately brought ff/libor down. It didn’t come all the way down to where the fed wanted it because the limited the size of the TAFs to $20 billion, again hard evidence of a shortfall in their understanding of monetary ops.

Simple textbook analysis shows it’s about price and not quantity. Charles Goodhart has over 65 volumes to read on this, and the first half of Basil Moore’s 1988 ‘Horizontalists and Verticalsists’ is a good review as well.

The ECB’s actions indicate they understand it. Their ‘TAF’ operation set the interest rate and let the banks do all they wanted, and over 500 billion euro cleared that day. And, of course- goes without saying- none of the ‘quantity needles’ moved at all.

In fact, some in the financial press have been noting that with all the ‘pumping in of liquidity’ around the world various monetary
aggregates have generally remained as before.

Rather than go into more detail about monetary ops, and why the CB’s have no effect on quantities, suffice to say for this post that the Fed still doesn’t get it, but maybe they are getting closer.

So back to the point.

Major themes are:

  • Weakness due to low govt budget deficit
  • Inflation due to monopolists/price setters hiking price

And more recently, the Fed cutting interest rates due to ‘market functioning’ in a mistaken notion that ff cuts would address that issue, followed by the TAF which did address the issue. The latest announced tafs are to be 30 billion, up from 20, but still short of the understanding that it’s about price, not quantity.

The last four months have also given the markets the impression that the Fed in actual fact cares not at all about inflation, and will only talk about it, but at the end of the day will act to support growth and employment.

Markets acknowledge that market functioning has been substantially improved, with risk repriced at wider spreads.

However, GDP prospects remain subdued, with a rising number of economists raising the odds of negative real growth.

While this has been the forecast for several quarters, and so far each quarter has seen substantial upward revisions from the initial forecasts, nonetheless the lower forecasts for Q1 have to be taken seriously, as that’s all we have.

I am in the dwindling camp that the Fed does care about inflation, and particularly the risk of inflation expectations elevating which would be considered the ultimate Central Bank blunder. All you hear from FOMC members is ‘yes, we let that happen in the 70’s, and we’re not going to let that happen again’.

And once ‘markets are functioning’ low inflation can again be translated via market forces into optimal employment and growth, thereby meeting the dual mandate.

i can’t even imagine a Fed chairman addressing congress with the reverse – ‘by keeping the economy at full employment market forces will keep inflation and long term interest rates low’.

Congress does not want inflation. Inflation will cost them their jobs. Voters hate inflation. They call it the govt robbing their
savings. Govt confiscation of their wealth. They start looking to the Ron Paul’s who advocate return to the gold standard.

That’s why low inflation is in the Fed’s mandate.

And the Fed also knows they are facing a triple negative supply shock of fuel, food, and import prices/weak $.

While they can’t control fuel prices, what they see there job as is keeping it all a relative value story and not ‘monetizing it into an
inflation story’ which means to them not accommodating it with low real rates that elevate inflation expectations, followed by
accelerating inflation.

There is no other way to see if based on their models. Deep down all their models are relative value models, with no source of the ‘price level.’ ‘Money’ is a numeraire that expresses the relative values. The current price level is there as a consequence of history, and will stay at that level only if ‘inflation expectations are well anchored.’ The ‘expectations operator’ is the only source of the price level in their models.

(See ‘Mandatory Readings‘ for how it all actually works.)

They also know that food/fuel prices are a leading cause of elevated inflation expectations.

In their world, this means that if demand is high enough to drive up CPI it’s simply too high and they need to not accommodate it with low real rates, but instead lean against that wind with higher real rates, or risk letting the inflation cat out of the bag and face a long, expensive, multi year battle to get it back in.

They knew this at the Sept 18 meeting when they cut 50, and twice after that with the following 25 cuts, all as ‘insurance to forestall’ the possible shutdown of ‘market functioning’.

And they knew and saw the price of this insurance – falling dollar, rising food, fuel, and import prices, and CPI soaring past 4% year over year.

To me these cuts in the face of the negative supply shocks define the level of fear, uncertainty, and panic of the FOMC.

It’s perhaps something like the fear felt by a new pilot accidentally flying into a thunderstorm in his first flight in an unfamiliar plane without an instructor or a manual.

The FOCM feared a total collapse of the financial structure. The possibility GDP going to 0 as the economy ‘froze.’ Better to do
something to buy some time, pay whatever inflation price that may follow, than do nothing.

The attitude has been there are two issues- recession due to market failure and inflation.

The response has been to address the ‘crisis’ first, then regroup and address the inflation issue.

And hopefully inflation expectations are well enough anchored to avoid disaster on the inflation front.

So now with the TAF’s ‘working’ (duh…) and market functions restored (even commercial paper is expanding again) the question is what they will do next.

They may decide markets are still too fragile to risk not cutting, as priced in by Feb fed funds futures, and risk a relapse into market dysfunction. Recent history suggests that’s what they would do if the Jan meeting were today.

But it isn’t today, and a lot of data will come out in the next few weeks. Both market functioning data and economic data.

Yes, the economy may weaken, and may go into recession, but with inflation on the rise, that’s the ‘non inflationary speed limit’ and the Fed would see cutting rates to support demand as accomplishing nothing for the real economy, but only increasing inflation and risking elevated inflation expectations. The see real growth as supply side constrained, and their job is keeping demand balanced at a non inflationary level.

But that assumes markets continue to function, and the supply side of credit doesn’t shut down and send GDP to zero in a financial panic.

With a good working knowledge of monetary ops and reserve accounting, and banking in general that fear would vanish, as the FOMC would know what indicators to watch and what buttons to push to safely fly the plane.

Without that knowledge another FF cut is a lot more likely.

more later…

warren

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Fed communications

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If conveying information is considered important for market function, why not just say it clearly and directly in a targeted announcement?

Kohn Says Fed Is Trying to Signal When Views Shift `Materially’

2008-01-05 11:15 (New York)
By Scott Lanman and Steve Matthews

(Bloomberg) Federal Reserve Vice Chairman Donald Kohn said the central bank has increased its communication on policy views to the public in the wake of the financial-market “turmoil” that began in August.

Fed officials have tried to signal when the central bank’s reading on the economic outlook shifted “materially” in between regular meetings, Kohn said in a speech in New Orleans. “We have tried to provide more information than usual to reduce uncertainty and clarify our intentions.”

Kohn spoke before a week in which Chairman Ben S. Bernanke and six other Fed policy makers are scheduled to deliver remarks. The speeches come amid increasing signs of danger to the U.S. economic expansion, including a jump in the unemployment rate to a two-year high and a contraction in manufacturing. Traders anticipate the Fed will cut interest rates again Jan. 30.

Still, investors “should understand” that officials “do not coordinate schedules and messages, and that members’ views are likely to be especially diverse” when circumstances are rapidly changing, Kohn said.

Kohn held out Bernanke’s last speech on Nov. 29 as a signal of a change in the Fed’s views. The chairman said at the time that volatility in credit markets had “importantly affected” the economic outlook and declined to repeat the Federal Open Market Committee’s October statement that inflation and growth risks were about equal. The Fed then cut rates on Dec. 11.

`Let People Know’

“We have attempted to let people know when our views of the macroeconomic situation had changed materially between FOMC meetings,” said Kohn said in prepared remarks at the National Association for Business Economics panel discussion, part of the Allied Social Science Associations annual meeting.

The vice chairman didn’t comment on the outlook for monetary policy or the economy in the text of his remarks.

Bank of Japan Deputy Governor Kazumasa Iwata and European Central Bank Vice President Lucas Papademos were also scheduled to speak in the same session.

Traders yesterday shifted to bets on 50 basis points of interest-rate cuts by the Fed this month from 25 basis points after U.S. hiring slowed more than forecast in December and unemployment rose to 5 percent. The Fed lowered its main rate a quarter percentage point to 4.25 percent at its last meeting on Dec. 11. A basis point is 0.01 percentage point.

Fed Speakers

Bernanke speaks Jan. 10 in Washington. Other Fed officials giving talks include Boston Fed President Eric Rosengren and Kansas City Fed President Thomas Hoenig, the last two policy makers to cast dissenting FOMC votes. Charles Plosser, head of the Philadelphia Fed, votes as an FOMC member for the first time this month; he will discuss his economic outlook Jan. 8.

The FOMC is scheduled to meet Jan. 29-30 in Washington.

Separately, Kohn said today that the FOMC’s new forecasts for inflation three years out do not represent an “explicit numerical definition of price stability,” something the committee decided against, but rather the inflation rate that is “acceptable and consistent with fulfilling our congressional mandates.”

Kohn, who said in 2003 that he was “skeptical” about a price target, chaired a subcommittee of officials that coordinated work on the Fed’s communication review that began in 2006. He suggested in September that his doubts about the idea had eased.

Inflation Expectations

“I expect that our new projections will provide some of the benefits of an explicit target in better anchoring inflation expectations while not giving up any flexibility to react to developments that threaten high employment,” Kohn said today.

He also echoed remarks by Bernanke that the Fed will continue to look for “additional steps” to improve communication.

Fed officials decided last year not to report members’ assumptions of the “appropriate” path of interest rates because of concern that investors would “infer more of a commitment to following the implied path than would be appropriate for good policy,” the vice chairman said.

Kohn, speaking yesterday at the same conference, said diverse views on the 19-member FOMC lead to better monetary policy decisions. “The authority of the chairman rests on his ability to persuade the other members of the committee that the choices they are making under his leadership will accomplish their objectives,” he said.

–Editor: Chris Anstey, Christopher Wellisz
To contact the reporter on this story:
Scott Lanman in Washington at +1-202-624-1934 or
slanman@bloomberg.net;
Steve Matthews in New Orleans at +1-404-507-1310 or
smatthews@bloomberg.net.

To contact the editor responsible for this story:
Chris Anstey at +1-202-624-1972 or canstey@bloomberg.net

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