The Fed is getting squirrely
The mercury pushed up toward 100 degrees in Memphis yesterday, and the humidity seemed determined to keep pace. It can get so oppressively hot in this part of the country that people just go inside and stay there when the sun is high. I joked to the wife last week that this must be one of the few places where you can occasionally have a legitimate fear of dying of thirst in your own front yard. These are some of my favorite days though because it means I’ll have all of the local mountain biking trails to myself. There will be no crowds at all and I can fly through the woods with very few distractions.
It was on one such ride yesterday that I saw what might be an omen. We’ve all seen squirrels wrestle with the “do I run left or do I run right” dilemma. This usually occurs as you barrel toward them in your car. It’s easy to see how the squirrels have a tough time with the decision. They have eyes only on one side of their head and the car is coming pretty fast…maybe it looks different out of one eye than it did the other…this way…no that way…and so it goes until it becomes a very close call.
Well yesterday on my afternoon ride there were a ton of squirrels on the ground. To my surprise the squirrels had some trouble with the “left or right” dilemma even with threats moving as slowly as me on a mountain bike in 100 degree heat. Some of this I figure was due to the fact that they are in a state park…they are used to seeing lots of people and maybe they get complacent about the magnitude of the threats they face.
Squirrel after squirrel darted back and forth in front of me as the miles went by. Ultimately though, one squirrel took far too long deciding if it would be “left or right.” Indecision paralyzed this squirrel as he darted back and forth in a tighter and tighter range until it was too late. It was left, right, left…and then right into the path of my bike. As he went under the front tire I realized that I just joined what must be a very small group of people in this world…people who have run over a squirrel while riding a bike. What struck me most about the deal was that he not only got hit squarely by the front tire, but that he bounced off the chain, and then got the rear tire as well…it was an abrupt and pointed lesson on the dangers of complacency and indecision.
As I finished my ride I couldn’t help but compare the squirrel’s dilemma to that of the Fed. Both have to make some big decisions, both have to be timely in their decision making, and both can get run-over if they stay in the middle of the road for too long.
Where are we now?
The Fed has put itself in a precarious position. Short term rates are at zero percent and the Fed’s balance sheet has swollen to well over $2 trillion over the preceding two years.
Our current situation is one where core inflation is low, unemployment is stubbornly high, and there is a very modest recovery underway. The risk the Fed has feared most is tightening too soon and choking off a blossoming recovery before it has a chance to get deep roots. On the other hand…if they don’t act soon enough and they let inflation get out of control they could do real damage as well. The Feds “too early/too late” dilemma isn’t much different than the squirrels “left/right” dilemma.
We know that they can’t/won’t wait until unemployment is significantly reduced and inflation is off to the races before they tighten. So the question is “when will they do it?”
Several Fed officials have given us guidance recently. Most recently the Minneapolis Fed President (Kocherlakota) and the Philadelphia Fed President (Plosser) have given us some color. As we discuss this issue keep in mind that there are two ways that the Fed can “tighten” monetary policy. The first is to simply raise the overnight rate. The second is to monkey with their balance sheet via selling securities or by simply halting the reinvestment of portfolio cash flows.
When will they tighten?
Kocherlakota (Minneapolis) said recently that his forecast is for PCE (the Feds preferred inflation measure) to be at 1.50% and for unemployment to be 1.00% lower by year end (as a point of reference the unemployment rate ROSE to 9.10% on Friday so this one isn’t going his way at the moment). He went on to say that if his forecast is correct then he would argue for a 50 bps increase in the overnight rate. His statements were more long winded and full of caveats and cautions regarding the problems of forecasting such things but he at least put some numbers on the board for us to look at.
Plosser (Philadelphia) began discussing his thoughts on tightening back in the 1st quarter. In a perfect world Plosser would like to see the Fed Funds Rate regain its role as the primary tool of monetary policy. To achieve this goal the Fed would have to shrink their balance sheet tremendously. In his 1Q speech he provided a look at how this shift might look if executed over two time frames. The first was a 12 month window and the second was over 18 months. Reviewing that data is beyond the scope of today’s update but if you would like to see it just let me know and I’ll shoot you the Powerpoint presentation where we reviewed the plan.
More recently Plosser has said that “somewhat tighter monetary policy is possible by the end of the year”. He acknowledges that the Fed will have to begin reversing course on monetary policy before all of the data look good…and that’s not a huge surprise. Nobody expects that the Fed will wait until the Unemployment Rate is back down to 5.00% before they decide “OK…now it’s time to tighten.”
What to expect?
This talk from the Fed is very preliminary. As a counterpoint to the items we just discussed we should consider last week’s statement from St. Louis Fed President Bullard. He noted that there is historical precedent for the Fed going on hold and staying on hold for a long time period. So while there is talk among some at the Fed about tightening policy, there is plenty of talk on the other side about sitting still.
In my opinion the Fed will let QE2 expire and then sit back and watch the data for a few months. They will want to see if there are any adverse effects from their departure from their role in that market. If the data are positive over that time frame we’ll hear more chatter amongst the members as to which way to go. This is not going to be a quick process…certainly not fast enough to make you feel better if you are sitting on a lot of cash…that should still be a fairly painful position as short term rates are likely to remain low for quite some time.
It’s very easy to see the first step in this process being the halting of portfolio cash flow reinvestment. This is a great way to test the waters because it’s a passive move. It shouldn’t be terribly alarming to the markets and it’s probably going to be the easiest thing to get the FOMC to agree upon.
If the markets don’t freak out over the move then you can begin a very well communicated plan to begin selling assets at a pace that the market can digest. This will be the first big step toward restoring Fed Funds to its role as the primary tool of monetary policy. If we get to a point where PCE is rising toward 1.50% to 2.00% then you should expect to hear a lot more talk about a hike in the overnight rate. Several Fed members have gone on record as saying that inflation will not be tolerated…even if it means raising rates with a high unemployment rate.
So today we have some very early discussions that are beginning to nudge the FOMC in two directions. How they proceed will depend entirely on the data…but at this point I can only hope that they are better at zigzagging than yesterday’s squirrel.
If you have any questions or if there is anything I can be doing for you just let me know.
Regards,
Steve Scaramastro, SVP
800-311-0707
Posts
No comments:
Post a Comment