Trust but Verify

There is a battle going on between the Federal Reserve and the market. It is over the outlook for the economy and the appropriate monetary policy.

The Federal Reserve position is clear. As it expected, the economy has slowed. However, as Chairman Bernanke said recently: “Outside housing and motor vehicle sectors, economic activity has, on balance, been expanding at a solid pace.” The Fed suggests that weakness in housing and autos is likely to be self-correcting and in any event unlikely to spill-over and undermine the overall economy.

Fed officials have consistently argued that the upside risks to inflation are greater than the downside risks to growth. It has maintained what is tantamount to a tightening bias since pausing in its tightening cycle near mid-year. Price pressures have not continued to accelerate but remain above levels that the Fed identifies as stability. The only dissent at the FOMC meetings has come from the hawks—Richmond Fed President Lacker—favoring a rate hike. No one has voted to cut rates.

The equity market participants would seem to agree with the Fed’s assessment of a soft-landing. Over the past month, the US S&P 500 rose 2.4%, easily outperforming European bourses, which outside of Spain, largely fell, and the Japan’s Nikkei, which posted a marginal loss.

And in the Other Corner

The debt and currency markets are less sanguine. Prices on various instruments seem to reflect the fear of a harder landing to the US economy.

Fed funds futures and the Eurodollar futures strip imply that the Federal Reserve is likely to cut its target rate in the spring. The yield curve—no matter how it is measured—has become more inverted—in the past a fairly consistent precursor of an economic downturn.

The dollar itself has slid over the past few weeks and has become the slide has become especially pronounced over the past week or so. On a trade weighted basis, it has declined by nearly 4% since the middle of October and over half that fall has been recorded since November 20. This change in the trade-weighted measure of the dollar is tantamount to some easing of monetary conditions. Economists may differ on the exact ratio, but the 4% decline in the dollar on a trade-weighted basis is roughly the equivalent of 25-40 bp of easing, if it is sustained. In effect then the market has eased policy for a Federal Reserve that is reluctant to do so.

It is as if the debt and currency markets are trying to give the Fed a wake-up call. They are saying the Fed historically has kept rates too low for too long and too high for too long. And the current Federal Reserve Board is the least experienced in modern history. Donald Kohn, the Vice Chairman has more experience than every one else on the board combined.

From the perspective of many economists, the Fed is whistling past the graveyard. To address the slowdown in 2001 and mitigate the impact of the collapse of the equity market bubble, policy makers created another bubble—in housing—and that bubble has now popped and the full extent of it is still working its way through the economy.

Many of the more pessimistic forecasts warn that housing and residential construction will not only be a headwind for the economy for the coming quarters, but are likely to have a broader and deeper impact than Fed officials seem willing to recognize.

One of the characteristics of the current cycle is that the market has consistently under-estimated the duration and magnitude of Fed tightening. Remember how the year began, “one and done” under Greenspan. There have been a number of swings in market expectations toward an early cut only to have it reconsidered.

Another one of the market’s bets that have proven consistently wrong is the bet against the US consumer. They are tapped out. They have negative savings. They took equity out of their homes to finance their excessive consumption. But the demise of the American consumer has been grossly exaggerated. The key to US consumption is income. And income continues to hold up fine. The latest data covering the month of October showed US personal income was up 5.8% year-over-year. The 0.4% monthly rise in October compares with an average monthly gain of 0.5% in Q3 and 0.2% in Q2.

Perhaps under the Greenspan Fed there might have been a greater chance for the FOMC cut interest rates. One of the criticisms after all of the Maestro was that he was a slave to the market expectations. This could be one of the reasons that the cottage-industry of Fed-watchers was decimated under his tenure as the uncanny accuracy of the front month Fed funds futures contract was widely appreciated.

It was not simply that the market became better at reading the Fed. Greenspan’s circuitous verbal jousting, the embrace of strategic ambiguity as a matter of principle, and his ad hocery approach to the conduct of monetary policy arguably mitigated some of the other forces working toward greater transparency.

The Bernanke Fed is different. It is widely appreciated that Bernanke is more comfortable with decision-making rules, as reflected in his advocacy of a formal inflation target. While there is little doubt that the Bernanke Fed monitors and places weight on expectations, like inflation expectations, he appears less inclined to follow the market.

If nothing else this is one of the consequences of Bernanke’s emphasis on greater transparency and clearer communication. There is no doubt where he stands. For the better part of the past six months, the message has been unambiguous and consistent. It has not been swayed by volatile and high frequency pieces of economic data. The Fed has not flip-flopped. Strong Q1 GDP did not prompt a panic response, like a 50 bp hike, that some observers favored. Nor did the initial 1.6% Q3 GDP—subsequently revised to 2.2%--a pace of growth that most industrialized countries would be content with—cause a panic cut, like some thought necessary.

In the battle for control of US monetary policy, we suggest betting on the Federal Reserve and the equity market. The debt and currency markets are too fickle and are subject to various other forces that might shape the signal that its prices are generating. However, we would not bet the farm or take the risk of ruin. In the words of the Great Communicator: Trust but verify.