Monday, 24 July 2006

Pause for thought on Fed pause

Last week saw data released showing that inflation persists in the United States economy. Whereas in the past such news had more often than not triggered falls in bond and stock prices, last week, markets essentially shrugged off the data.

On 19 July, the Labor Department reported that the consumer price index (CPI) rose 0.2 percent in June, in line with expectations. However, the core CPI that excludes food and energy rose 0.3 percent, higher than the 0.2 percent expected, and maintaining the same pace as the preceding three months.

It so happened that later that same day, Federal Reserve Chairman Ben Bernanke gave his testimony to the Senate Committee on Banking, Housing, and Urban Affairs. In that testimony, Mr Bernanke said that "the anticipated moderation in economic growth now seems to be under way". This "should help to limit inflation pressures over time". He also said that the Federal Reserve "must take account of the possible future effects of previous policy actions".

The testimony was enough for markets to reach their own conclusion: The Federal Reserve hopes to pause in its tightening campaign soon. Expectations for a rate hike in August fell immediately after the testimony while US bond and stock prices rose and the US dollar fell.

Stock investors would also have been further encouraged by Mr Bernanke's assessment that "the economy should continue to expand at a solid and sustainable pace" even as core inflation declines. Clearly, the Federal Reserve is intent on, and believes it is capable of, achieving a soft landing in the economy, probably similar to what was achieved in 1994-95 (see my earlier commentary entitled "Despite weakness in US housing, recession not yet inevitable"), if not better.

If everything goes as smoothly as Mr Bernanke says, the outlook for the economy and for markets is reasonably sanguine. However, there are, in my opinion, some risks to a sanguine outcome even if it is true that the Federal Reserve thinks it can pause soon.

The first risk is that the Federal Reserve's forecast for the economy turns out to be wrong. The central bank is trying to steer the economy along a tightrope: Contain inflation on the one hand without inducing a recession on the other. With sentiment on the housing market continually deteriorating, many doubt that a recession can be avoided. And even if it can, doubts remain over whether inflation can be tamed if the Federal Reserve indeed pauses soon. While the current federal funds rate of 5.25 percent looks high compared to the 12-month core inflation rate of 2.6 percent, it is less than one percent above the overall inflation rate of 4.3 percent.

The second risk, especially for investors but also for the economy, is the way markets react to events and data. According to the Federal Reserve's own forecast, core inflation as measured by the price index for personal consumption expenditures excluding food and energy is projected to continue to increase for the next few months from 2.1 percent in May to between 2.25 to 2.5 percent by the fourth quarter and to fall back to 2 to 2.25 percent by the fourth quarter of 2007. But the latter range is still around the current core PCE inflation rate. There is every possibility that markets may get uneasy with such an inflation trajectory and take inflation expectations and bond yields higher, especially if the overall inflation rate also remains persistently high. Incidentally, that would be a reversal of the low-interest-rate conundrum of 2004-2005, which also serves as a reminder of how market reactions can deviate from official forecasts and undermine official policy.

The third risk is how the Federal Reserve itself reacts to the data and markets. While various Federal Reserve officials have emphasised that they need to take into account policy lags, market skepticism of the success of monetary policy, especially with a new Federal Reserve chairman, might force them to act more decisively than they currently plan. And remember that the risk here is two-way: while some may feel that the Federal Reserve needs to do more to contain inflation, others may react to signs of economic slowing to urge the central bank to maintain a more accommodative monetary stance at the risk of higher inflation. Would the Federal Reserve and its new chairman be able to resist calls for action that takes it away from its preferred path?

The Federal Reserve's perceived intent to pause may have helped markets recover somewhat from their May and early June turmoil, but I think the risks outlined above should give investors themselves pause for thought.

1 comment:

Tax Shelter said...

the bond market is not stupid. it has a lot of the smartest people in the business. they have concluded that there is no inflation. economists and equity investors are wrong.

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