March 29, 2006
Learning the new Fedspeak
Curious reaction from both markets and pundits to yesterday's statement from the FOMC accompanying the decision to boost the fed funds rate another 25 basis points.
Five- and ten-year yields are up 10 basis points from Monday, and Macroblog has an impressive summary of people who were worried about what the Fed's latest statement implies for what may lie ahead.
Here's what the Fed actually said:
The slowing of the growth of real GDP in the fourth quarter of 2005 seems largely to have reflected temporary or special factors. Economic growth has rebounded strongly in the current quarter but appears likely to moderate to a more sustainable pace. As yet, the run-up in the prices of energy and other commodities appears to have had only a modest effect on core inflation, ongoing productivity gains have helped to hold the growth of unit labor costs in check, and inflation expectations remain contained. Still, possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures.
The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.
The threat of more hikes is given emphasis by the opening paragraph, which baldly states that the Q4 slowdown was "temporary" and that growth has "rebounded strongly", though it "appears likely to moderate".
So what about stating baldly that:
The slowing of the growth of real GDP in the fourth quarter of 2005 seems largely to have reflected temporary or special factors.
Isn't the statement, like, true? Hadn't every fair-minded analyst already concluded that 2006:Q1 GDP growth is going to look better than 2005:Q4? Or is it just unsettling to hear the Fed say plainly what everybody is already thinking? And what's wrong with concluding that:
further policy firming may be needed.
That's true, too, isn't it? The Fed is saying that, if it sees more evidence of inflation picking up, it will raise rates higher. Isn't that what everybody expects them to do? They didn't say they're committed to do so, rather that they're watching the incoming data to see whether it proves necessary.
I think that one of the sharpest differences between new Fed Chair Bernanke and his predecessor Alan Greenspan will prove to be their communication skills. Greenspan seemed to think that it was his duty to speak obscurely, making sure he covered all the bases and giving mere hints of where things were really headed. People accordingly tried to decipher his Delphic pronouncements, running for cover when there seemed to be a hint of something newly negative.
To me, this was a very striking contrast with Bernanke's recent speech about the yield curve. This is a marvelous read, which I view as a completely open window into how Bernanke is interpreting current developments, openly offering his hypotheses along with his doubts, and the evidence for and against.
If you read the Fed's latest statement not as an arcane set of tea leaves that have to be deciphered, but rather as a straightforward statement of where we stand that should be taken at face value, then I don't see anything to be alarmed about. When people ask, "what does Bernanke mean?", my first instinct is, "exactly what he says."
You might come to like it, once you get used to it.
Posted by James Hamilton at March 29, 2006 01:05 PMdigg this | reddit
Yes, the FOMC statement says what it says. But what isn't said also matters. Specifically, the markets were looking for a "softer" statement, a slight shading that would suggest that the Fed is less intent on raising rates in May -- and didn't get it. No mention of the housing market -- that seems odd. The Fed could certainly pause in May, but on balance, the statement suggests that Fed policymakers view a May hike as "more likely than not." The markets were merely caught leaning the other way.
Posted by: Scott Brown at March 29, 2006 04:09 PM
Isn't the statement, like, true?
Ya but who likes a party pooper.
Posted by: dryfly at March 29, 2006 06:12 PM
Thanks Dr. Hamilton:
I completely agree. I think that many financial market participants, for many reasons some biased of course given the industry is transaction driven, read far too much into what the Fed is 'believed' to be saying vs. its literal translation. Moreover, and people should remind themselves of this, that the Fed worries about 'potential' inflation growth, which could be 2-years down the road. Although core inflation growth is not that significant at present, it is increasing year-over-year and continued high energy prices are likely in the back of the Fed's mind.
Finally, and I think that former Treasury Secretary Robert Rubin said it best when he stated years ago that "people worry way too much about the Fed..." Besides, much of the academic literature on monetary policy, that of Christopher Sims in particular, has shown that interest rate changes do not have that strong of a real impact on the economy especially to the extent they are believed to have, however, it does make for entertaining financial talk shows and all of the drama that accompany them....
Posted by: Kirby Thibeault at March 29, 2006 07:36 PM
I am relieved that the Fed has finally acknowledged that asset and commodity inflation are the seed of future core inflation.
It is my feeling that the financial industry has been leveraging inexpensive, borrowed funds to control commodity prices through the futures market. Rather than being an efficient market for price discovery and transaction, the futures market currently seems to me to be a merchant mechanism for controlling and raising prices. The nearly 50 % increase and subsequent collapse of natural gas prices would not be my definition of "efficient" price discovery but a rather inefficient profiteering. The current pricing of metals, driven by domination of the thinly traded futures market by financial interests rather than market equilibrium, also appears to be inflationary profiteering rather than efficient pricing. Eventually, the asset and commodity inflation will work it's way into the general prices of goods and services that will even register on the official inflation scale.
The most recent Fed announcement appears to acknowledge the leading indicator value of the current, exhuberant commodity inflation.
Posted by: anon at March 29, 2006 09:08 PM
Freudian slip from the Fed statement?
"in a related action, the Board of Governors approved a 25-basis-point increase in the discount rate to 5-3/4 percent"
Posted by: anon at March 29, 2006 09:16 PM
No, the discount rate really was raised to 5.75% from 5.50%, nothing Freudian about it
Posted by: cuibono at March 30, 2006 09:58 AM
This is very important too!!!
"ongoing productivity gains have helped to hold the growth of unit labor costs in check, and inflation expectations remain contained"
Posted by: Anonymous at March 30, 2006 12:02 PM
What he says is one thing, but what it translates into in action is another. There will still be a time of the market learning where to put the emphasis.
Posted by: Lord at March 30, 2006 01:45 PM
I agree with what you said, so the following is a side point.
My problem with the most recent FOMC statement is that it focuses on the wrong horizon. My view is that the FOMC should either stick to the snapshot of the current economy (my preference) or talk about their forecast for the economy 12-month ahead (the horizon that is relevant to policy actions). Talking about outlook a quarter or so ahead focuses the market attention on the wrong horizon, and given the 6 to 18 month lag of policy actions, is more likely to lead to an overshooting of the tightenings.
Posted by: pat at March 30, 2006 02:03 PM
With regard to anon's point above about natural gas prices, rather than profiteering I think those price changes really did represent efficient price discovery. Going into the winter there were many predictions of extreme natural gas shortages being possible, largely due to the interruption in supply after the Gulf hurricanes, as well as longter term structural factors. On that basis gas was bid up to very high prices.
However the U.S. winter was one of the warmest on record, meaning that natural gas demand was much lower than usual. As gas stockpiles rose, futures prices fell, producing the price whipsaw which anon interprets as manipulation. Compare with what happened in England, which has had a cold winter and has seen extreme spikes in natural gas prices as a result. That could easily have happened in America, and that possibility is what the market was pricing in last fall.
Posted by: Hal at March 30, 2006 10:58 PM
At the time of Mr Sims' research there was not the mountains of credit and home debt funded by floating rate products.
Rates are floating upward exerting pressure on household budgets. That pressure will increase. Pay the mortgage or buy the new toy?
Seniors, however, are displaying rational exhuberence. Rates for CD's are increasing though the benefit to the general economy will be slow due to interest being received at the end of the term.
Posted by: bill at March 31, 2006 03:06 AM
Monday, before the meeting, the 2/10 spread was -3 bps. Today, it is +3.5 bps. A steeper curve is normally associated wtih less restrictive Fed policy, rather than more, yes? I understand that the entire curve jacked up. I understand that lots of effort was made to make the analysis fit the market move, but that seems to make any analysis pretty superfluous. But it is pretty easy to find support for the notion the market response suggests less, rather than more, tightening ahead. If you are going to make the analysis match the move after the fact, you might find yourself changing your analysis a lot.
The argument that "the market" anticipated a substantial change in the language misses a great deal. For one thing, there is only one price at any given time and place for a financial instrument, but there are lots of ideas that went into setting that price. "The market" doesn't "think" at all, but it is a really bad anthropomorphism to claim it "thinks" one and only one thing about a future event.
There were plenty of pre-FOMC pieces written to suggest the language wouldn't change much. "Continuity" and "smooth transition" and all that.
And in fact, the statement didn't change that much. We now have two meetings at which "may" has been used to describe the likelihood of more rate hikes. I dunno about the rest of the world, but to me, "may" carries the implication of "may not" right along with it. Hoenig said today policy is in the upper end of the neutral range, that growth and hiring will slow this year, and that inflation won't accelerate.
Posted by: kharris at March 31, 2006 01:14 PM
If you have the time and inclination, please refer to The Federal Reserve Bank of Boston's Conference Series No. 42 'Beyond Shocks: What Causes Business Cycles.' In that research, which includes some exceptional research and analysis on historic business cycles and monetary policy, Sims work raised doubts that 'the systemic component of monetary policy either causes fluctuations or can offset them, at least through interest rate movements.' Of course, he received some scepticism about his findings but when Laurence Christiano tried to statistically demonstrate that Sim's findings were wrong, he couldn't.
Sim's arguments go as follows. "One cannot determine the influence of monetary policy simply from observing changes in interest rates and output. If, for example, rapid expansion of private demand for credit systemically causes all interest rates to rise near the end of an expansion, this rise in interest rates should not be interpreted as the cause of a subsequent slowdown; it is a cause of previous strong demand." Moreover, he emphasizes the importance of the interaction of several economic variables and their outcome on output vs. relying solely on any one single variable.
Posted by: Kirby Thibeault at April 1, 2006 05:47 PM
Historically the correlation between bond yields and fed funds was extremely high so if you were right on the direction of one you were right on the other and it did not matter. Moreover, it was almost impossible to tell which one was responsible. For example, regressions imply that fed funds has a much bigger impact on the stock market PE then bond yields. But over the past year the maket PE and bond yields have both been flat while fed funds rose sharply. So we have the situation where financial markets watch the Fed because they expect it to lead to a drop in the stock market PE and a bear market. But because of the Greenspan conundrum the historical negative impact of higher fed funds on the stock market PE has not worked this year.
But does this also imply that the traditional impact on the economy will not work either?
This also raises a completely new question, as US dependence on foreign capital has risen has the ability of the Fed to implement an indepependent monetary policy vanished?
Posted by: spencer at May 3, 2006 07:25 AM
I hear Bernake speak at a closed door Federal Reserve Bank Meeting where I was interning. He definitely says what he means i.e the days of Fed speak are over. Still, couldn't this cause a collective action or groupthink problem, if we all just start putting the fed's expectations/analysis (even when they miss the target e.g core CPI) into our fundamental calculations?
Posted by: Ken at June 9, 2006 08:28 AM