What will the Fed do next?

James Hamilton January 2nd, 2007

In talking about the Fed’s likely next move, it’s useful first to review how we got to where we currently are. The Fed now clearly understands that it overdid the stimulus in 2002-2004, and brought us uncomfortably close to a resurgence of inflation as a result. The high inflation rates for the headline CPI during 2005 might be dismissed as a temporary influence of energy prices. But the upward drift by the start of 2006 of other measures, such as the core CPI (measured by removing energy and food prices from the total) or the median CPI (measured by the price change of the expenditure-weighted median item purchased by consumers), were not so easily ignored. Here’s how Fed Chair Ben Bernanke described his concerns last June:

core inflation measured over the past three to six months has reached a level that, if sustained, would be at or above the upper end of the range that many economists, including myself, would consider consistent with price stability and the promotion of maximum long-run growth. For example, at annual rates, core inflation as measured by the consumer price index excluding food and energy prices was 3.2 percent over the past three months and 2.8 percent over the past six months. For core inflation based on the price index for personal consumption expenditures, the corresponding three-month and six-month figures are 3.0 percent and 2.3 percent. These are unwelcome developments.

One of the key red flags for the Fed was the growing spread that developed in May and June between the yields on nominal and inflation-adjusted 10-year Treasuries. At the end of April Bernanke was still taking some comfort in the fact that these remained below 2.5%:

The stability of core inflation is also enhanced by the fact that long-term inflation expectations–as measured by surveys and by comparing yields on nominal and indexed Treasury securities–appear to remain well-anchored.

But when this spread started to signal a long-run expected inflation rate of 2.7% in the weeks following those remarks from Bernanke, that in my mind was a key factor in persuading the Fed to continue hiking the funds rate all the way to 5.25% in June.

As the above graph shows, these long-run inflation expectations have since come back down, stabilizing around a much more desirable 2.3% level. Markets evidently have now have come to share the faith in Bernanke that I have had from the beginning. On the other hand, that faith is predicated on the belief that the Fed is willing to sacrifice some short-run GDP growth in order to keep inflation from returning, and those core inflation figures have been coming down rather stubbornly.

William Poole, President of the Federal Reserve Bank of St. Louis, stated in November that

“‘We need a policy that is disciplined enough to get the job done, but not more so,” Poole told reporters after a speech in Wilmington, Delaware. “If all the information taken together suggests that we are not making progress, then I will be among those who will push for a tighter policy.”

Poole said inflation expectations are “well controlled… The market does believe we’re serious” [about containing inflation]

He reiterated that he sees the outlook for the fed funds rate as “roughly symmetrical,” meaning the chances of an interest-rate cut and an increase are about equal. … ”I can imagine data coming in that would make me want to tighten policy, and I could imagine data coming in that would make me want to ease policy,” Poole said.

And just what might be the circumstances in which the Fed would choose yet another rate hike? I suppose that if those core inflation numbers and nominal-TIPS spreads again surged, the Fed might be forced to consider it. But I view that as rather unlikely at this point, and even if it happened, the Fed would have to be very reluctant to tighten any further. If we want to avoid a recession (which I’ve always believed that Bernanke very much does want to avoid), you really can’t go any farther than we already have, and indeed the verdict is still out on whether a recession is already in the cards based on what the Fed has done so far. Realistically, I think we can take the possibility of another rate hike off the table.

And what about a rate cut? If we do see widespread defaults sending housing into a freefall from here, then I certainly would expect the Fed to start cutting rates, though at that point it would be too late to do much good. But in my opinion, such a prospect, while a tangible possibility, is not the most likely outcome.

And what is the most likely outcome for housing? Even if home sales fall no further, the inventory of unsold homes will continue to be a drag on residential construction, meaning that below-average GDP growth and employment growth will likely continue for some time. Would that be enough to cause the Fed to ease on interest rates? My guess is that it would not. Precisely because a resurgence of those inflation fears would put the Fed in such a tight spot, the Fed may be quite willing to see the current slow growth continue for several more quarters as long as the trajectory appears to be holding stable rather than spiraling down.

And the data that came in during December seem largely consistent with the claim that things are not getting any worse. Certainly the stock market is not signaling any fear by investors that a recession is about to begin: s&p500.png

For the equities of homebuilders in particular, the Dow Jones Construction Index continues to reflect a market consensus that the worst is behind us:

Fed funds futures, which started out the month betting on a rate cut by the March meeting, had by the end of the month converged to a predicted fed funds rate for April that is not far from the current 5.25%: