August 04, 2006
A pause it shall be
The last month has been something of a cliffhanger for Fed watchers. But today the market seemed to make up its mind.
The federal funds rate is an overnight interest rate on interbank loans of deposits those banks hold with the U.S. Federal Reserve. Because this interest rate is quite sensitive to the total quantity of these deposits that the Fed allows, the Fed can set a fairly precise target for the federal funds rate. The actual fed funds rate on any given day is determined by the supply and demand of the lent funds for that day, but the market rate usually ends up pretty close to the Fed's target.
The Federal Reserve Open Market Committee reviews its target at meetings held about every 6 weeks. The FOMC has chosen to raise this rate another 25 basis points at each of its previous 17 meetings, bringing the target to its present value of 5.25%. The big question over the last month has been whether the Fed would opt for yet another hike at next Tuesday's meeting.
The Chicago Board of Trade offers a futures contract whose payoff is based on the average value for the effective fed funds rate over all of the calendar days of a specified month. The price of the contract implies a particular value (such as 5.35%) for what that month's average fed funds rate might turn out to be. If the actual value turns out to be less than this (say, 5.25%), the seller of the contract will have to compensate the buyer for the difference (paying $41.67 per basis point in the standard contract).
|Date||Change in |
|Nov 6, 2002||-0.50||1.25||-0.155|
|Jun 25, 2003||-0.25||1.0||+0.025|
|Jun 30, 2004||+0.25||1.25||+0.005|
|Aug 10, 2004||+0.25||1.5||+0.015|
|Sep 21, 2004||+0.25||1.75||+0.005|
|Nov 10, 2004||+0.25||2.0||0.000|
|Dec 14, 2004||+0.25||2.25||0.000|
|Feb 2, 2005||+0.25||2.5||0.000|
|Mar 22, 2005||+0.25||2.75||0.000|
|May 3, 2005||+0.25||3.0||0.000|
|Jun 30, 2005||+0.25||3.25||0.000|
|Aug 9, 2005||+0.25||3.5||0.000|
|Sep 20, 2005||+0.25||3.75||+0.005|
|Nov 1, 2005||+0.25||4.0||0.000|
|Dec 13, 2005||+0.25||4.25||0.000|
|Jan 31, 2006||+0.25||4.5||0.000|
|Mar 28, 2006||+0.25||4.75||0.000|
|May 10, 2006||+0.25||5.0||-0.005|
|Jun 29, 2006||+0.25||5.25||-0.005|
The rest of us can look at the interest rates specified in the futures contracts for a quick summary of what participants in the market are expecting the Fed to do next. Historically, the fed funds futures prices have done a pretty good job of anticipating. Since 1994, the average absolute value of the difference between the futures price as of the end of the previous month and what the actual average for that month turns out to be has been 5 basis points. The prediction 2 months ahead has a mean absolute error of 9 basis points, and 3 months ahead 15 basis points. One standard of comparison that is often hard to beat with financial data is the no-change forecast. The average squared forecast error from a no-change forecast is about 3 times as big as the squared error implied by futures prices for the 1, 2, or 3-month horizons.
In the more recent past, the quality of the fed funds futures predictions has gotten even better. The average one-month-ahead absolute forecast error since 2003 was well below 2 basis points. By the day before any recent FOMC meeting, the market basically had the outcome nailed. The change in the price of the current-month futures contract on the day of each of the last 14 FOMC meetings has been less than a single basis point, and by far the most common outcome is for there to be literally zero change on the day of an FOMC meeting. In recent years, the market has thus had essentially no doubt as to the outcome of any meeting.
In contrast to this boring predictability, the current month has finally brought some real excitement for Fed watchers. If the Fed does raise the target on August 8, that would justify an August futures price of 5.44% = (8/31) X 5.25 + (23/31) x 5.50, whereas if it doesn't change, the correct value would be 5.25%. For most of July, the August contract traded right smack in the middle of those two possibilities. During the past few weeks, evidence mounted that inflation has crept up (see for example Tim Duy, Mark Thoma, William Polley and Dave Altig), lending credence to those who advocated another rate hike. But the news of further deterioration on the real side has been equally depressing (see for example Calculated Risk, Brad DeLong, and Nouriel Roubini), arguing for a pause. Bad news from both sides seemed to keep the futures price balanced in the middle.
But the pause camp received some powerful new ammunition with today's employment report from the Bureau of Labor Statistics. This showed only 113,000 new jobs added in July, whereas 150,000 or so are usually needed to keep up with the growing number of job-seekers. The result was that the unemployment rate jumped from 4.6% to 4.8%. I also pay attention to the household survey of employment. This was even more disappointing, showing no growth at all but rather a decline of 34,000 people fewer employed in July.
In any case, the BLS release seems to have settled the argument, as least as far as the CBOT Fed watchers are concerned. The August contract has fallen 5 basis points as of this morning on the release of the BLS statistics. For comparison, the biggest single one-day change in the current-month futures contract going back to January 2002 was 3 basis points. As news goes, the market treated today's report as quite a bombshell.
And I must say that conclusion works for me. Yes, inflation is a real concern, meaning rate hikes at subsequent meetings remain a possibility. And inflation worries will doubtless prevent the Fed from lowering rates back down to the degree that a deteriorating economic outlook might otherwise warrant. But inflation is a longer run risk that cannot be solved with short-run monetary policy. I see the current game plan for the Fed to be to try to engineer as much of a slowdown as possible without causing a recession.
And I agree with the market that 5.25% may be about as far as we dare go at the moment.
Posted by James Hamilton at August 4, 2006 11:41 AMdigg this | reddit
The eurodollar futures market is pricing in almost 50 bp in easing between dec 06 and dec 07. It is no longer news to say "a slowdown is coming." Its old news now. Its just a question of how slow will it get.
James do you have any ideas on what might re-accelerate the eocomy out of the slump? In other words, if there is a recession what will pull the economy out? Last time it was housing -- so what will it be this time?
I can think of a few things:
1) Growth in exports (Chindia booming and dollar falling)
2) Housing again as Fed brings rates down to 1%
3) Tax cuts as the republicans fight to stay in power
None of the three above look particularily good. Is there anything I'm missing?
Posted by: vincentm at August 4, 2006 01:21 PM
Vincentm, I believe there is a potential at some point for an increase in business investment. Also, don't forget that, other things equal, lower imports would also mean higher GDP. I agree that further tax cuts or too-aggressive interest rate reductions are not at all appealing.
Posted by: JDH at August 4, 2006 01:33 PM
Makes you wonder the market reaction if the FED DOES NOT pause as Bernanke shows "his manhood", so to speak?
Posted by: Johnson at August 4, 2006 02:35 PM
big mistake if he pauses..anyhow, they have to raise. This pause, if at all, will only spur them to hike later.
Posted by: sam at August 4, 2006 04:02 PM
JDH: Please explain why we will see more business investment if consumer demand falls off. My understanding (as a non economist) is that business investment has not been particularly robust during this expansion as compared with prior ones. If businesses didn't see fit to invest during the recent consumer boom why would they start now?
Posted by: Gail at August 5, 2006 05:19 PM
Hi Jim -
Two comments, and one question.
One, what other labor data bear watching? As much as I like the CPS (and concur that the unemployment rate change was breathtaking), I also pay attention to weekly jobless claims. They have been hovering just voer 300k for weeks now, down from the 320 or so average of last year, down from the year before, and down from the 400k levels of 2003. As for the CPS, 4.8% is still below what some would call the natural rate, yes?
2. Is it appropriate to suggest that 150k payroll jobs are normal? Research from the Atlanta Fed indicates that 100k is the new normal. The story here is demographic -- all the baby boomers retiring.
Q. HOw does the excessive fiscal stimulus factor into good monetary policy now? Perhaps you have already answered this, so a pointer is all I'd ask in lieu of my vote for a new post on this topic! And if higher rates attract more investment, how does that then shape the balance of payments?
My money is still on a Fed raise. If so, then I think Wall Street may finally get the message that the CES (payroll) survey is not the indiciator of interest any more.
Posted by: Kane at August 5, 2006 10:59 PM
Tim, that sort of looks like 3 comments/questions to me.
(1)The two labor-related measures that go into the index of leading indicators are average workweek and initial unemployment claims. Some people look at help-wanted measures such as the Conference Board's index, but separating out the trends in the technology of job advertising and search are at least as difficult as those we've discussed for interpreting the more popular labor market indicators. The BLS JOLTS data set also has lots of detail.
(2) I agree that this 150,000 figure is only a rough rule of thumb. The complicating issue, as you observe, is identifying the trends in labor force participation. One way to think about the "correct" value is to identify what level of job growth would have been needed last month to keep the unemployment rate from rising. Of course, that gives you an estimate in units of the household survey (from which the unemployment rate derives) rather than the establishment survey that more people are interested in.
(3) I think integration of monetary and fiscal policy is an important issue at the moment. Basically the Fed has been charged with keeping inflation under control, meaning whatever fiscal stimulus Congress votes for, the Fed has to undo it, at the cost of less residential and business investment and an aggravated current account deficit. As you know, I'm in the camp of those who see little sound economic justification in the current economic environment for having large fiscal deficits.
Posted by: JDH at August 6, 2006 08:34 AM
Gail, my comment about investment spending was in response to what I understood to be Vincent's hypothetical question, to wit, if we do get into a recession, what component of GDP spending might we hope to see lead the recovery out of that recession a year or two later? The reason I raised investment spending as a possible candidate for this is due precisely to the observation you make-- it has recently been somewhat low by historical standards, meaning there's certainly a potential for more.
Posted by: JDH at August 6, 2006 08:39 AM
Off-topic: James, do you have contacts who can comment intelligently on the status of the Cantarell oil field?
Posted by: Dave Schuler at August 6, 2006 02:29 PM
Dave, I don't have any first-hand information, and have just read the same things that you probably have. There doesn't seem to be much question that Cantarell is in rapid decline, though so far Mexico seems to have succeeded in making up for the losses with other production. Mexico's May production (and Jan-May 2006 average) of 3.3-3.4 mbd is still right where it's been for the last two years.
Another item on my "to-do" list is to try to look into this some more, and if I find anything useful, I'll try to include it in a subsequent post.
Posted by: JDH at August 6, 2006 06:58 PM
Thanks. Another darned thing to worry about.
Posted by: Dave Schuler at August 6, 2006 08:40 PM
I like your final sentence: "And I agree with the market that 5.25% may be about as far as we dare go at the moment." Indeed your sentence is not a conclusion of any economic reasoning, but I like it because most economists playing the "macro" game can now rest for a few weeks (it's August after all and they deserve a break until Labor Day). Let's hope that tomorrow the Fed agrees.
It is not my intention to mention again ideas that you have shown no interest in discussing. You believe that the 5.25% policy may imply that inflation may eventually go down with no large decline in growth rates. I hope you're right (altough you have no argument to support it--don't worry neither Bernanke, De Long and the others have one) but more important I hope one day you can explain why it has been necessary for the Fed to pay the high cost of lower growth for keeping recorded inflation below 4%. The only reason I can think of is that now economists run central banks.
Posted by: Edgardo at August 7, 2006 06:19 AM
Edgardo, I believe I've stated on any number of occasions my strongly-held belief that the Fed overstimulated the economy in 2002-2003. Indeed, throughout my career I've been a strong critic of stop-go monetary policy, in which the Fed tries too hard to get the economy going when things are slow, only to then end up inducing a recession when they try to reign inflation back in.
Perhaps the reason I don't repeat that statement even more often is that it is too easy, cheap, and obvious a point to make in 2006 that the Fed was too stimulative in 2002-2003. The tough question is instead, what should we do about it now?
I believe it will require a decline in the real growth rate (such as I perceive to be now happening, not a conjecture) to bring inflation down. What I'd hope to avoid is negative growth rates (an economic recession). Whether we can accomplish this is an open question in my mind.
The other factor responsible for the current inflation, of course, is that the tremendous rise in oil prices has meant that it's not within the Fed's power to choose as favorable a point on the short-run inflation-output tradeoff as might have been previously attainable. I do not think the Fed would have been in quite the current jam if oil prices had held steady this last six months.
Posted by: JDH at August 7, 2006 07:12 AM
While the CBOT's fed funds futures contract is the bellweather financial instrument for Fed watching right now, the CBOT introduced binary options on the FOMC's target rate itself on July 12. The trading of these contracts has had much less volume and a much smaller open interest than the fed funds futures, but these options have great potential to become the better indicator of the market's views on FOMC actions. I've been tracking their probability of a rate increase at the August 8th FOMC meeting, and it is almost identical to that implied by the August futures contracts. Check it out at http://www.cbot.com/cbot/pub/cont_detail/0,3206,1415+39847,00.html
Posted by: Jose at August 7, 2006 10:10 AM
JDH, it seems like oil prices are exogenous and there is not much the fed can do about commodity price inflation. True, there may be some price passthrough from energy costs to prices of goods and wages, but have there been any studies done that preventing such exogenous inflation is the right thing to do? Afterall, price stability of commodities is not a goal monetary policy.
So why is it does that the fed is in a bind? Cant they just lower rates and be prepared to live with higher inflation as dictated by energy prices?
Posted by: vincentm at August 7, 2006 01:37 PM