Dollars and Jens
Thursday, August 23, 2007
fed funds target considerations
The fed, by which I mean Bernanke, seems eager not to prop up financial markets, and only to target interest rate policy toward keeping the real economy in balance. This, however, argues more and more for a cut in interest rates.

The first point to note is that 5.25% has generally been regarded as slightly restrictive. The entire yield curve has spent most of the past 14 months below that rate, and this has been consistent with the FOMC statements implying greater concerns about inflation than about economic weakness. They raised it to that point to tap the brakes — and inflation has, slowly, been coming down.

In fact, the spread between the TIPS and the nominal treasury notes has tightened over time; at 5 years, it was 2.3% or 2.4% at the beginning of July, 2.2% at the end, and is now right around 2.0%. (Using the rule of thumb that CPI, to which TIPS are indexed, overstates inflation by about half a point, this implies that inflation over the next five years is expected to be right where various memebers of the FOMC have suggested they want it.) These expectations are built around expectations that the fed will cut rates in the next few months; this certainly seems to open room for the fed to cut rates if it wants to without sparking (potentially self-fulfilling) expectations of high inflation.

So why would it want to? The housing recession has, up to this point, been largely contained — there has been a lot of expectation that new wealth and solvency constraints on homeowners would reduce consumer spending, but that hasn't been seen yet. The newest data, though, may be showing some signs of weakness. The market turmoil does seem to have had at least some impact; a few financial firms in particular have announced layoffs; unfortunately the August employment situation report that comes out in early September will provide a snapshot of the weekend after the major liquidity injections took place, and it may be that the fed will meet before favored statistics are available to quantify the effects of recent turmoil. Even the July report, though, showed an uptick in the unemployment rate from 4.5% to what was reported at 4.6%, but in fact was 4.65% if you go another decimal point. (In point of fact, the margin of error is likely to be between 0.01% and 0.1%.) Claims of unemployment insurance have been inching upward for the past couple months. Somewhat vexingly (not to be wishing for disaster!) none of this is unambiguous; it simply suggests a weakness that is particularly easy to read into the data if you've been expecting it.

Monetary policy generally acts with a lag that is longer than is often appreciated. On one hand, it is because of this that it doesn't make a lot of sense for the Fed to get overeager to act before the next meeting; an interest rate cut a month earlier wouldn't help a lot versus one in September, and there will be more data on unemployment claims, consumer spending, inflation, and, of course, what path the financial markets take between now and then, not to mention a cornucopia of anecdotal information collected by the regional federal reserve banks. On the other hand, it suggests that actions be taken based on where the economy is headed, and it's easier at this point to see sources of future weakness than an excessive willingness to pay higher prices for goods.

(Incidentally, the actual average overnight fed funds rate topped out at 5.03% Monday, and has otherwise been below 5% every night for basically the past two weeks. It could well still be that the target will ultimately be drawn around the interest rate being hit without the rate being brought back up to the target first.)

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