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The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.


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August 09, 2005


Ho-Hum, Now What's To Come?

I can do no better than to quote my colleague John Carlson (he of funds-futures options fame):

Analysts greeted the FOMC Statement with a great big yawn. I cannot recall a time when the market reaction was so imperceptible.

You will find the informed wrap-up in all usual excellent places: from William Polley, from Mark Thoma, from pgl, from the New Economist, from Brad DeLong.

In addition to noting pgl's disappointment, I take note of an earlier post from Professor Polley, in which makes a point that deserves some consideration:

What strikes me as odd, and a bit worrisome, is the idea that the economy has to hit a "soft patch" (for lack of a better word) to give the Fed the signal to stop raising rates.

If that was the game, I would worry too.  But I don't think that is the game.  I hope you will excuse me if I quote myself quoting myself:

A “neutral” monetary policy—one that avoids both inflationary and disinflationary pressures (as well as both artificial stimulus and unwarranted restraint on the pace of real economic activity)—requires that the funds rate target adjust to the evolving demand in credit markets as consumption, investment, and employment expand in anticipation of continued growth...

Now, as the economy strengthens and investment and employment growth recover, the neutral setting of the funds rate is moving up. The distance it will go depends on myriad factors, most (if not all) of which will only be revealed in time (perhaps at a measured pace). 

Just prior to the June FOMC meeting, the spread between 10-year Treasury yields and the federal funds rate was about 100 basis points.  After today's funds rate target change, and at the close of the market this afternoon, the spread is about 90 basis points.  To me, that does not spell a lot of tightening with this move.

Now James Hamilton would argue, I think, that I should not take much comfort in this:

... over the last two months, the trend in long yields has reversed, and long-term rates have come back up significantly. However, even if we only focus on the last two months, the rise in long rates is less than the rise in short rates. It's also interesting to note that inflation-indexed Treasuries have gone up together with the 10-year nominal yield, suggesting pretty strongly that it's not inflation fears that have contributed to the increases in the long rate, at least up to this point. Instead it looks much more like the market has come to expect ongoing rate hikes, driving the 10-year rate up through expectations of a higher fed funds rate over the next few years.

I fully agree that there is scant evidence of any run-up in inflation expectations that would account for the rise in long-run rates.  But I'm not sure at all that I buy into the conclusion that all we are seeing is the expectation of further funds rate increases being built into the long rate.  Long-term real interest rates have something of a life of their own.  To be sure, arbitrage requires that the expected path of short-term rates be consistent with yields on longer-lived bonds, with appropriate adjustment for term premia, etc., etc.  But longer-term real rates are driven in large measure by rel economic activity -- and that is indeed picking up.

So, I'm not ready to conclude that the policy stance has changed much since early summer.  That does, of course, leave William's other very good question unanswered:

Though I don't think another one or two quarter point moves will throw us into a tailspin, I worry that the FOMC has painted themselves into a corner linguistically. How are they going to break it to the market that the rate hikes are about to pause?

August 9, 2005 in Federal Reserve and Monetary Policy | Permalink

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Comments

My wish that we would keep interest rates from rising comes less from the soft patch concern and more from the concern that we are still a ways from full employment. But I'll concede that I'm in the left leaning Max Sawicky camp. If I believed we were near full employment, I'd be advising the FED to raise rates just a bit.

Posted by: pgl | August 09, 2005 at 06:49 PM

Did you notice that business inventories in Japan grew at over 11%, well above the expected level? It appears to be, at least in part, export led and attributed to the recovery in the U.S. If world investment demand begins to recover, that will also put upward pressure on rates.

Link to Bloomberg report:
http://quote.bloomberg.com/apps/news?pid=10000006&sid=axcCs_2aNGAU&refer=home

Posted by: Mark Thoma | August 09, 2005 at 08:57 PM

I meant investment, not inventories. To be precise, it was machinery orders, excluding shipping and utilities

Posted by: Mark Thoma | August 09, 2005 at 09:00 PM

I'm with you on this one, but I'll throw in once again, elimination of the 30yr, reduction of the 10yr as a % of total debt issued, new hedge funds & even fx buyers has really limited the value of "old" method thinking.

Posted by: bailey | August 09, 2005 at 10:21 PM

My soft patch concern refers to what I have been reading and hearing in the media all day about how the Fed needs to slow the economy. That's also pretty much what was said back in 94-95 and growth did slow. I must admit to being a little skittish about thinking of the neutral funds rate drifting up when real GDP growth is under 4% and job growth is at 200k/month. With 4.5% or 5% and 300k/month it would be a much easier call.

When the funds rate was at its nadir, it was easier to sell the idea that the Fed needs to get ahead of the inflation curve. But at some point in the near future, if real GDP growth is still in the 3-4% range and job growth in the 200k/month range it is going to be harder for me to accept the sales pitch--especially if oil prices remain high and core inflation remains low.

Really what I would like to see is a pause in the action to see if the long end of the yield curve can catch up (i.e. move up). I don't think a break from the rate hikes in December would unleash the dogs of inflation. And that's where you have my real question about how to communicate that to the markets.

Posted by: William Polley | August 10, 2005 at 12:29 AM

ACTUALLY THIS ONE WAS A MAJOR SURPRISE..

COGNITIVE DISSONANCE?
IF we view FOMC statements as attempts to make policy transparent.. theY must
be taken in context of the Market's Expectations Going IN..
THE FED KNOWS WHAT THE MARKET IS FIXATED ON AND ALL EVERYTHING MUST BE
VIEWED IN THE SAME CONTEXT..
THE SAME WORDS REPEATED EXACTLY WILL HAVE DIFFERENT "MEANING" GIVEN THE
CONTEXT OF THE ECONOMIC DEBATE..
That said reading the FOMC statement one cannot be but struck that this
STATEMENT WAS A 'SURPRISE" AT lEAAST to that group that see economic growth
accelerating, labor costs rising,home prices still moving up..THOSE THAT THINK
THAT THE FED IS ONCE AGAIN BEHIND THE CURVE....
THOSE THAT YESTERDAY WERE ACTUALLY LOOKING ND PRICING WHAT IF THE FED GOES 50
TRADES IN THE MARKETPLACE..
TAKE A LOOK AT THE VOLUME IN THE NOV 95.87 PUTS IN FED FUNDS....AS WELL AS
THE RUN FOR OCTOBER 95.50 PUTS ON DEC EURO'S.. OPTIONS THAT ONLY PAY OFF IN THE
DIRE 50 BP'S MOVE BY SEPTEMBER/NOVEMBER...

WHILE WE FULLY EXPECT A BERRY ARTICLE IN MINUTES TO AMPLIFY THESE DIFFERENCES
HERE IS WHAT THE FED ACTUALLY SAID .. AS OPPOSED TO WHAT IT COULD HAVE SAID...


The FOMC said, "Aggregate spending, despite high energy prices, appears to have
strengthened since late winter."
AS MERRIL LYNCH SAYS: What is with the word "appeared"?

So, just as the Fed did not hop on the 'soft patch' bandwagon in the past few
press statements,the nuance today is that it is not going to jump on the
'Goldilocks' bandwagon either.
The Fed is essentially not sure if this spending pace is going to be sustained.

The Fed kept the reference to "labor market conditions continue to
improve gradually."
Again, why leave in "gradually" when many economists saw last Friday's
nonfarm figure.....(from ML...maybe because half the 207k payroll gain came from
retail,restaurants and local government education)?

One of the big changes today was in the comment on inflation.

Back in June 30, the statement read, "Pressures on inflation have stayed
elevated, but longer-term inflation expectations remain well contained."

Today that statement reads, "Core inflation has been relatively low in recent
months and longer-term inflation expectations remain well contained, but
pressures on inflation have stayed elevated."

Not only did the Fed switch the sentence around the qualifier was flipped this
time but it also introduced the acknowledgment that the core inflation numbers
of late have been benign (and by making mention of it, ostensibly the FOMC does
not believe this is a fluke or they would have used the word "appeared").


More important.. to consider the Fed made this more tame statement on inflation
even in the face of the back revisions to last year's core PCE deflator.

This could be a sign that the Fed has looked through those revisions since they
merely reflected imputed changes to financial services pricing (and hence
elevate theimportance of the market-based core PCE, which stayed at 1.5% last
year).
AS ML... SUMMARIZES:

Core inflation "has been relatively low" (why not "higher than we thought")?
Productivity is "robust" (why not "slowing")?
Spending only "appears" to be strengthening (why not "unequivocally")?
Labor markets are improving "gradually" (why not "substantially")?
Inflation expectations remain "well contained" (why not "on the rise")?

JUST TO TOP THINGS OFF BY THE WAY DON'T FORGET PRODUCTIVITY..

Q2 growth came in at 2.2%, versus a forecast of 2.0%.

The Labor Department's estimate of unit labor cost growth in the second quarter
was 3.5%.
If you subtract productivity growth of 2.2%, you are left with growth in unit
costs of 1.3%.
SURPRISE?.. THIS ABOUT 1/2 TO 1/3 OF WHAT MOST ECONOMISTS HAD BEEN
PREDICTING...
THIS IS OF COURSE THE KEY TO THE GSPAN/BERNANKE DATA SET..

GIVEN THE STATEMENT WHICH PROBABILITY PATH WOULD ONE PUT THE FED ON TODAY.....
FORGETTING WHAT YOUR FRIENDLY GURU SAYS SHOULD OR SHOULDN'T BE THE CASE..

Posted by: sjonas | August 10, 2005 at 08:54 AM

In my opinion, the US economy is still stuttering.

From the GDP report:
Real final sales of domestic product -- GDP less change in private inventories -- increased 5.8 percent in the second quarter, compared with an increase of 3.5 percent in the first.>

A substantial percentage of GDP growth was derived from inventory selling. Which is good news, it allows an increase in production, local or foreign, and both should help the global economy. Nobody wants a major slowdown in China either...

The BID index (Baltic Dry Index, link below), which has seen its shipping tariffs halved to 2002 levels, confirms a significant slowdown in raw material requirements --or an important slowdown in manufacturing.

The last 25 bps hike was either dumb or gutsy --the US economy is still too fragile. In any case, I see the ceiling for the Fed fund rates dangerously close, or the last rate increase will bring the whole deck of cards tumbling down.

http://www.findata.co.nz/Markets/Quote.aspx?e=INDEX&s=BDI

Posted by: Joe Rotger | August 10, 2005 at 11:51 PM

I guess I can't bracket...
Missing GDP report excerpt:

The real change in private inventories subtracted 2.32 percentage points from the second-quarter
change in real GDP after adding 0.29 percentage point to the first-quarter change. Private businesses
reduced inventories $6.4 billion in the second quarter, following increases of $58.2 billion in the first
quarter and $50.1 billion in the fourth.

Real final sales of domestic product -- GDP less change in private inventories -- increased 5.8
percent in the second quarter, compared with an increase of 3.5 percent in the first.

Posted by: Joe Rotger | August 10, 2005 at 11:55 PM

Don't the regional Fed presidents and their staffs have a fairly good handle on the gut-level of exuberance or pain that the major lenders in their respective regions are experiencing? Isn't that the ultimate "test" for whether monetary policy is "getting tight" or "feels too loose"?

In other words, until the regional Fed presidents are starting to really feel some heat, we just aren't "there" yet, regardless of what the most advanced modeling or historical perspectives may suggest.

-- Jack Krupansky

Posted by: Jack Krupansky | August 15, 2005 at 08:57 PM

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