Postcards from Old Europe – Fed Watching

Last Friday saw the release of payroll data for the month of May. As most of you know the number came in at a not too hot, not too cool +248k. The accompanying data was heartening as well, with the workweek rising to 33.8 hours. More work means that more “stuff” and services are being produced which should in turn lend support to GDP.

All this positive news has given rise to expectations that the Fed will move aggressively with regard to tightening monetary policy. Fed watchers have become ever more vigilant in their attempts to deduce Fed policy via public speeches held by Fed worthies.

The last in line of speeches by Alan Greenspan was at the International Monetary Conference in London, England on June 8. This speech was looked on with much interest by markets because it was almost a year ago (on June 3, 2003) that the Fed Chairman made his now epic “firebreak” comment in which he emphasized the Fed’s commitment to fight deflation. He said

One important issue here is that we’ve worked with inflation over the years. We know how it functions, we know its dangers, we know how to address it. It’s a difficult job to contain inflation, but we’re not all that uncertain about it as we are with the issue of deflation. We’re far more unclear on the issue of deflation, and as a consequence, we need a wider firebreak, in logging and forestry terms, because we know so little about it. So we lean over backwards to make certain that we contain deflationary forces

Fed watchers were looking at this year’s speech to see if Greenspan was going to a) declare deflation dead and b) speak about the need to quash the inflation beast.

The Fed chairman delivered (mostly) on a) but failed to give rate-hawks much ammunition as his view of the economy’s future policy was mostly balanced. But markets are still expecting a quick series of rate hikes going forward.

I don’t think that we’ll actually see that. I think that the Fed is actually engaged in actively steering market’s perceptions of what will come to pass. Thus managing of expectations has been going on for a while now and may actually constitute the monetary policy “Plan B” proposed by Fed Governor Bernanke.

The Fed engineered much of the current recovery by letting markets know that rates will remain low for a “considerable period”, thereby switching from an economic metric such as inflation, to a calendar metric. The Fed is now engaged in an attempt to assuage markets that it is not behind the curve with regard to inflation without giving the impression that they will tighten in such a way that will kill the recovery. That is why the Fed is saying “we’re vigilant, we’re looking at inflation, we’ll act. But we’ll act in a steady fashion”.

The problem that the Fed (and everyone else) has is that inflation data has been quite volatile with the first months of the year showing subdued (“quiescent”) prices rises while the most recent data has shown stronger gains. Just not enough data to form any kind of trend. Higher prices for many raw materials have been well publicised and have provided many companies with the possibility to raise prices on the back of newspaper headlines. This is serving to inflate profit margins and is raising consumer’s expectations of inflation in the process.

The summation: I believe that the Fed will hike, but not by as much as many people think (say around 75bp by year end). The risk is in market expectations of inflation running rampant. This will the force the Fed to act to counter – or “manage” – these expectations. This could in turn really hurt economic growth in the third or fourth quarter.

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