(originally published on January 12, 2008)
In an unusually blunt speech to a business group in Washington this week, Fed Chairman Ben Bernanke hinted that the economic outlook had indeed taken a turn for the worse into the new year. He noted that 'the baseline outlook for real activity in 2008 has worsened and the downside risks to growth are now more pronounced', effectively rewriting the Dec 11 FOMC statement. This marked shift may possibly have been driven by last week's Labor Department report that showed that the jobless rate jumped to 5% in December and the first decline in private sector employment since 2003. Bernanke pledged that the Fed stood 'ready to take substantive additional action' and 'provide adequate insurance against downside risks'.
Similar sentiments were echoed this week by other Fed speakers as well. Fed Governor, Frederic Mishkin, a former collaborator with Bernanke on academic research, suggested that 'waiting too long to ease policy... might well increase the overall amount of easing that would eventually be needed'. Philadelphia Fed Bank President Charles Prosser, who is considered by economists as the toughest on inflation, moderated his stance this week, hinting that slumping consumer spending is his biggest concern at the moment.
The consensus has now solidly shifted toward a 50 bps rate cut as shown by the chart from the Cleveland Fed below. Fed funds futures contracts traded on the CBOT suggest that the odds of a 75 bps rate cut this month jumped to 43% from virtually zero earlier in the week, suggesting that some traders at least see the chance of a move before the FOMC meeting.
Implied probabilities of different outcomes of January 30 FOMC meeting (as of January 19)
Why is this change of heart from the Fed significant? Is it significant at all? Bernanke has generally sought to avoid front-running the committee. By that token, such an aggressive message suggests that there has been some committee-wide communication in the past few days. The Fed seemed to have underestimated the magnitude of the credit shock and its subsequent fallout. Its monetary policy stance 'appeared to somewhat restrictive', as admitted in the minutes of the Dec 11 meeting released last week. Despite denying that his models indicate a recession in the making - the politically correct thing to say - the Fed chairman may now be worried that his worst fears are indeed coming true. The 14-page speech contained just a single paragraph on inflation and even that seemed to downplay the threat of inflation against the larger evil of slowing growth, signaling a resolution to the long-standing debate over the competing risks of slower growth and faster inflation. By stating that monetary policy remains the Fed's best tool for pursuing its macroeconomic objectives, Bernanke has primed the market for a 50 bps rate cut when the FOMC meets later this month while also keeping the possibility of a inter-meeting rate cut open even as it pursues the other tools in its arsenal such as the Term Auction Facility.
Comparison of Fed Funds rate, Unemployment and inflation
As shown in the chart above, it is not unusual for inflation to be rising moderately as the Fed embarks on a rate cutting spree in response to faltering growth (brief period of stagflation). The weakening economy usually takes care of the inflation. This is what the Fed is now betting on. But could inflation be a bit more persistent this time? Import prices rose by 10.9% in 2007, the biggest calendar-year increase since 1987. Data released this week indicated that US trade deficit in November widened to $63.1 billion, its most in two years, driven by a phenomenal surge in oil prices, overshadowing record levels of exports that have been driven by a weaker dollar and growing demand from Asia and Latin America. Back-of-the-envelope calculations suggest that the average price of oil in 2007 would be around $65. A sustained $90 and above price of oil in 2008 would inflate that trade deficit by another $100 billion. Resurgence of tensions with Iran this week provide further supply side shocks that could keep the ground for oil fertile in 2008 as well.
The Fed found itself stuck between a rock and a hard place and bravely decided to lean towards the side that hurts less. Bernanke is a smart man... he sure realizes the options before him. The economy suffers from not just illiquidity, but also insolvency, which cannot be resolved with monetary policy alone. In its dance of denial, the Fed has remained behind the curve for over a year in its mistaken assessment of the risks of a recession. The aggressive Fed easing now will only limit the depth and extent of a recession; it will in all probability fail to prevent it. Further, inflation concerns aside, the risk of a dollar free-fall and the risk of foreigners pulling the plug on the external financing of the nation's burgeoning current account deficit will limit how much the Fed can ease. When the economy is grappling with a glut like now (glut in housing, autos, consumer durables sectors etc., similar to the glut of tech capital goods in 2001), pushing more money into the system is akin to pushing on a string.
Markets have rallied every time the Fed eased and/or suggested further rate cuts. But these rallies seem to be running out of steam and are becoming increasingly short-lived. Bernanke's speech this week met with only a tepid response. Like 2001, a full fledged bear market might get underway when investors at large realize that the Fed easing will not prevent a recession. As the popular pop song goes, it may just be a case of 'too little too late'!
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