August 06, 2004

What Is the Federal Reserve Going to Do Next Week?

Billmon writes:

Whiskey Bar: Out of the Blue:Alan Greenspan will have to decide what he thinks about all this, and react accordingly. Not surprisingly, expectations for interest rate hikes have declined substantially, although the futures market still expects the Fed to nudge rates higher by a quarter of a point next week. (Forcing the Bush-Cheney campaign to try to spin away yet another painful economic reality.)

At the moment, though, the bond market seems more impressed by the "stag" than the "flation" in the July report. Bond yields have plummeted, which has helped supply some badly needed support for the stock market, which otherwise looks awfully vulnerable. While the trends in today's jobs report aren't totally clear, it seems safe to say that none of them are encouraging for corporate profits or for earnings multiples (how much investors are willing to pay for those profits.)

In particular, the downward revision in job growth for May and June suggests the second quarter "soft patch" in the economy isn't going to harden any time soon...

What will the FOMC do next week in light of this very weak employment growth number? Probably what it was already planning to do: raise the federal funds rate by 25 basis points.

Remember, the FOMC makes monetary policy based not on where the economy is now, but on where it thinks the economy will be in a year.

Posted by DeLong at August 6, 2004 05:17 PM | TrackBack | | Other weblogs commenting on this post
Comments

It appears that the FOMC has a very serious decision to make. My business is very strong but some signs of softness among lots of my clients and their customers as lots of manufacturing has shifted overseas.

I hope they are looking for the long run in their decison and not neaar term political considerations that have dominated the actions for the last couple of years.

Posted by: pfknc on August 6, 2004 06:05 PM

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"Let it be"

Posted by: El Gringo on August 6, 2004 06:29 PM

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I have to confess I don't understand how the Fed's actions actually affect the rest of the world. It seems to me that moving the fed funds rate has little or no near-term effect on longer term rates (which actually affect investment decisions, I assume). It wouldn't surprise me if the effect was mainly psychological. In any case, the FOMC has only a very blunt instrument in its hands which is presumably most effective if used repeatedly. So the Fed, on this argument (if it can be called one), should stick to its plan and nudge the fed funds rate up another quarter point.

But if the stock market has another couple of bad days Monday and Tuesday, they may not have the guts.

Posted by: jam on August 6, 2004 07:18 PM

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Brad DeLong writes:
>
> Remember, the FOMC makes monetary policy based not on
> where the economy is now, but on where it thinks the
> economy will be in a year.

OK, so this makes sense. But does that then mean that the FOMC thought the economy would be completely in the toilet after 9/11, when they very, very aggressively reduced rates? (Or is that a special exception?)

On a related note, there is I presume a distinction between the monetary policy and the implementation, right? The Fed could decide we'll be going gang busters in a year, so rates should go up, but would decide to implement this as a a predictable series of small increases rather than trying to nail the target (say) every quarter. But then if that's true, I'm not sure how the actual implementation can have much effect, since it would be anticipated by the markets, who would set (especially) long-term rates at whatever seemed appropriate given current conditions and predictions about the future given (as some small part) the outlook of the FOMC.

The markets seem to be saying: rates are going to remain at or near historical lows.

Posted by: Jonathan King on August 6, 2004 09:32 PM

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This dance with the fed is making me long for an ECB style central bank, where the central bankers are told to maintain price stability, and nothing else.

It would make elected officials so much more --- responsible.

Posted by: Stirling Newberry on August 6, 2004 10:13 PM

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The Fed should be making policy based on where the economy will be in a year, but in practice it is always reacting to where the economy is today. Larry Meyer's book makes this very clear.

Posted by: Bruce Bartlett on August 7, 2004 12:46 AM

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Prof. DeLong wrote:

"Remember, the FOMC makes monetary policy based not on where the economy is now, but on where it thinks the economy will be in a year."

Perhaps that is how the Fed *should* to its job. If Greenspan is truly keeping an eye out on the economy when it is setting interest rates, and knowing that interest rate changes take 6 to 9 months to percolate into the economy, can you please explain why Mr. Greenspan chose to surprise markets by announcing several large (50 basis point) cuts between official meetings, right in the middle of a trading day. To me, those rate cut announcements were timed to juice up the stock market. Most companies announce their earnings before or after the trading day. Why can't the Fed wait a few measly hours to announce its rate cut decisions? I can only think of one reason -- to juice up the markets (which is what usually happened every time such an announcement was made.)

And why is Mr. Greenspan so eager to drop rates at the slightest hint of real or imagined problems, but very reluctant to raise rates when the economy and the markets are going gangbusters?

If rate cuts are really tied to the economy, why is it universally accepted that Mr. Greenspan won't raise rates aggressively this year (at least when everone thought a few months ago that the economy was overheating and ripe for rate hikes) ahead of elections? Why should political timetable interfere with a rate regime, especially if the rate regime is meant to merely bring the rates back on par with inflation?

And why is Mr. Greenspan meeting so frequently with White House officials. A report I heard a couple of months ago noted that when President Clinton was in power, Mr. Greenspan barely went to the white house once a month. Now, he is there practically every week. Working too closely to advance the political goals of the current White House occupant?


Posted by: bt on August 7, 2004 01:59 AM

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Alan has to go to the WH all the time because he has to keep explaining what he is doing to Bush --Clinton understood it the first time.

There is no evidence that any Fed chairman but Volcker based policy on anything but current economic conditions. The basic formula (7.5 plus inflation less the unemployment rate )explained almost all fed funds rates moves since the 1950s except under Volcker and even during his term it got the direction of changes or turning points right.

Question>> If following this policy rule generated inflation in the 1960s and 1970 and holding rates above the implied level in the 1980s generated deflation, why has going back to
the same rule in the 1990s also generated disinflation? lags, international developments,
inflation expectations, luck ???

Posted by: spencer on August 7, 2004 05:30 AM

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Within the employment rate, hours worked rose 0.3% and average weekly earnings were up 0.6%. Do not overreact to the headline number, the economy is weakening but not collapsing. The Fed will raise rates a quarter point and then wait till December to raise them 50 points.

Meanwhile as bonds rallied the dollar collapsed.

Posted by: spencer on August 7, 2004 05:34 AM

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"...the disappointing state of the labor market today..."

Tomorrow's Barrons:

~~~
... we haven't yet discussed the real culprit -- the soaring price of gasoline at the pump.

The investment side of gross domestic product -- equipment (+10.0%), structures (+5.2%), and residential housing (+15.4%) -- was behaving well enough. So were exports (+13.2%), government (+2.3%), and inventory rebuilding (which can't be expressed that way).

If the higher price of gas hadn't placed a choke-hold on the consumer spending (+1.0%), GDP growth in the second quarter would have been significantly greater.

To see by how much, consider that from the first quarter to the second, average prices jumped about 17%. Money that consumers would have spent on other items was allocated to gasoline. If approximately the same number of gallons were bought, then real consumer spending on gasoline was not affected on way or the other. But real spending on everything else was.

Do the math, and it turns out real consumer spending would have grown at an annual rate of 3.0% instead of 1.0% without the price increase. This would have raised second quarter GDP growth from 3.0% to 4.5%.

Gains in payroll employment would have felt the buzz.
~~~

"...the FOMC makes monetary policy based not on where the economy is now, but on where it thinks the economy will be in a year."

Tomorrow's paper again:
~~~

Here's one reason to believe we may well living through a pause that refreshes only mean-spirited folks: The unusually strong performance of the venerable indexes published by the Institute for Supply Management, which are among Alan Greenspan's favorites...

[A] reading of 50 is considered "neutral" on the ISM Composite, while anything above 50 indicates expansion.

With July just reported, the ISM Composite has averaged 62.3 since January. A reading of 62.3 has correlated historically with an out-of-sight 7.1% expansion in gross domestic product.

At that rate of growth, expect a hiring panic...

http://online.barrons.com/public/main/

Posted by: Jim Glass on August 7, 2004 12:01 PM

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Jim, care to make a side wager (or two)?

Care to wager on that GDP number for Q3? i'll take the under, you can have the over.

Care to wager that we'll have a "hiring panic," which i'll define as meeting Bush's expectations at the time of the so-called stimulus package, namely, 300K new jobs per month in Q3? I'll take the no side of that one.

I see no basis for either of these to happen, or even come close to happening....

Posted by: howard on August 7, 2004 06:54 PM

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Howard,

Naughty, naughty. With June personal consumption spending below the Q2 average, the starting point for PCE in Q3 looks likely to be low. Pretty strong PCE growth would be needed just to trend, much less put in a strong quarter. You're trying to take advantage of poor Jim.

The fact that ISM's headline factory index has run at a level all this year that corresponds to a 7.1% rate of real GDP growth seems a pretty clear sign that the relationship between growth and the ISM index has changed. One easy GDP forecasting trick is to stack up all the sector data, then shade the estimate in the direction suggested by ISM. In the first Q2 estimate, however, that trick would have put you well above the actual result.

Posted by: kharris on August 7, 2004 10:25 PM

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kharris, me? try to take advantage of a nice, honest, reasonable, straightforward guy like Jim Glass? Perish the thought!

Posted by: howard on August 8, 2004 09:39 AM

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