Archive for February 18, 2010

Firing Blanks Can Still Cause A Stampede

February 18, 2010 1 comment

I suppose that we ought to deal with the last things, first. The Federal Reserve this afternoon hiked the discount rate to 0.75%, prompting a further selloff in Treasuries after what had already been a less-than-stellar day (TYH0 closed down 15/32nds, and another 5 ticks after the announcement). What is the Fed up to?

The discount rate increase has no practical, economic significance. Although use of the discount rate window no longer carries quite the stigma it once did (partly because the Fed, during the crisis, tried hard to encourage banks to use it), it is still a fairly unattractive source of funds when uncollateralized 3-month rates (LIBOR) are lower.

The hike in the rate also has no signaling significance, since the FOMC can (and has) be very vocal about what their plans are for removal of accomodation: to wit, they have no plans to remove it any time soon.

The Fed itself confirmed these two points in the press release announcing the change, which said in part “The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy.” It is hard to get clearer than that.

So then what is the point of this move? I see three possibilities:

  1. There really is no point. They were bored, knew they had to do this eventually, and did it.
  2. The hike in the discount rate – changes in which are initiated by member reserve banks – might be a small sop to Kansas City Fed President Hoenig, who has been dissenting hawkishly of late. I think that this is at least partly a consideration.
  3. The Fed wants the yield curve to be flatter, since a curve this steep tends to imply expectations of higher forward inflation; moreover, psychologically an optically-more-hawkish FOMC might keep long rates from moving up too much. By adding another hint that 0.9% 2-year note rates are untenable, the Fed hopes to scare money into more productive uses or at least further out the yield curve.

If this latter possibility is any part of the decision, or even if it isn’t, the Fed is playing a dangerous game right here. Long rates have been threatening support (as I showed yesterday), and markets already are nervous about the removal of a major buyer of this paper. Hinting that tightening policy may be coming sooner than people think – even while saying the opposite – risks causing a technical break higher in long rates while short rates stay relatively anchored since the Fed is certainly not going to do anything while Greece burns, the EU dithers, and European banks sweat. The Federal Reserve is firing blanks, because they can’t afford to risk firing real bullets…but the noise can still stampede the cattle.

The technical condition of the market is looking pretty poor. Initial Claims today rose back to 473k, dashing hopes that last week’s surprising drop to 440k reflected the true trend. Claims have now been 472k or above in four out of the past five weeks. It is hard to ignore the implication that the underlying run rate, if it isn’t worsening from the 435k-455k rate seen in mid-Dec to mid-Jan (which, because of the difficulty of seasonally adjusting, have larger-than-normal error bars), certainly is no longer improving. This is worrisome, because if the U.S. isn’t the engine of growth for the world right now, who is? China, who is actively tightening policy? Europe, dealing with Round 2 of the banking crisis? The dollar is rallying because people are reaching the conclusion that we are the engine, but this engine is still pretty weak.

On Friday the BLS will release the monthly CPI figures. I wrote about some of the common cognitive errors people make when thinking about CPI on Tuesday (see article here), but a good friend (thanks DW!) sent me something that will appeal to the people who are concerned that we are on the brink of a crazy inflationary episode in the U.S., and I thought I would share. Specifically, he sent me almost eleven trillion-one dollars. Zimbabwe dollars. These currency notes were printed over a period of just two years, from 2007 to 2008, and the sequence will tell the story better than economic statistics can:

1 dollar, Zimbabwe

A Zimbabwean Buck isn't what it used to be.

"I remember when this cost only 1 dollar. A few months ago."

"This is nothing. You should see my coin purse."

Yesterday this bought a car. Today, a sandwich.

"I only have a 10 trillion. Can you make change?" "Sorry, since you started that sentence the price has gone up."

I think this is a terrific rebuttal of the Keynesian interpretation of inflation. Zimbabwe certainly didn’t inflate because it is pressing on the limits of its potential output. It inflated because the reserve bank dumped lots of money into the system. I think that people who are cavalierly unconcerned about domestic inflation right now because of the output gap need to explain how Zimbabwe happens. Inflation is caused when too much money is matched up with too few goods, so the price of money in terms of goods declines (or, equivalently, the price of goods rise).

Strictly speaking it isn’t only the amount of money, but the amount of money that is spent and that involves a quantum called money velocity. In this country, the only thing which has saved us to date from the inflationary consequences of the money printing has been the decline in money velocity (which never collapsed, thanks to the Fed’s efforts to add leverage in addition to money). MV=PQ, and in this case the decline in V immunized the rise in M to some degree. But V will not contract ad infinitum.

Indeed, if you look past the housing price collapse, which pressured rents, the rest of core inflation is rising at better than 3%. I have talked about core-inflation-ex-housing in the past and I will do so again in the future because it is a useful way of looking around the immediate effects of the deflating housing bubble. But here is the simplest form of the question: if the economy narrowly averted a depression, and brandishes a capacity utilization statistic in the low 70% range with 10% unemployment, then how is New Jersey Transit – which itself is certainly not at capacity – able to contemplate a 30% price hike, as they are currently doing? You might object to that example, since demand for transit in the New York City environs is fairly inelastic (although there are ample substitutes to NJT!). But that isn’t the only example. What about beer? See the story here from last year (ignore the part about prices being increased to make up for volume declines. Anyone who has gotten an MBA – and I imagine that includes the management of Anheuser Busch – knows that only works if demand is inelastic and that probably doesn’t apply to the demand for Bud).

You won’t find any forecasting-by-anecdote here; some prices are always going up while others are going down (at least, in low-inflation environments), so those anecdotes are proof of nothing. But they are illustrative of the concept I want to get across: focusing only on endogenous supply and demand without considering exogenous factors like a crate of money washing up on the beach (or in the macroeconomics sense focusing on aggregate supply and aggregate demand without considering the quantity of money) will not produce the right intuition, reasoning, or forecast.

Speaking of inflation forecast, CPI is released tomorrow with economists expecting 0.3% on headline and 0.1% on core inflation, bringing the year-on-year change to +2.8% overall and +1.8% on core. The headline seems a touch low to me, although not enough to worry about. The forecast for core seems about right or even a smidgen high. The model I follow expects core CPI to keep declining slowly through Q3, but actual year-on-year core CPI is already above the model forecast and another +1.8% result would actually be somewhat of a concern to me as it would suggest the disinflationary tendencies are ebbing a bit ahead of schedule.

As usual, I will calculate the core-ex-housing number, which isn’t part of the release, and talk about it in my next post.

This January number has special implications for the TIPS market. The April 2010 TIPS bond, which matures April 15th with a notional amount tied to an interpolation between the January and February CPI figures, will see half of the uncertainty go away when the Jan print is under our belts. Accordingly, if NSA CPI is much different from the 217.05 implied by the current price of the Apr-10 TIPS (and ironically, that level matches the economists’ forecasts as well), you can expect that bond to move rather sharply.

Most folks won’t care as much about the April 2010s, a two-month piece of paper that will be half nominal as of tomorrow, when there are $8bln in 30-year TIPS to prepare for next week. But I care. I care, dang it!

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