Thursday, October 05, 2006

Kohn and Plosser sink the bond market

Fed Vice Chair Donald Kohn spoke last night in New York on his economic outlook. His speech sounded a good bit more hawkish than Poole or Hoenig's recent speeches. I think the key quote for markets is the following:

"Even if my relatively favorable forecast comes true, the level of short-term interest rates that will produce this forecast remains uncertain. Obviously, as my FOMC voting record indicates, I believe that, for now, the current level of short-term rates has the best chance of fostering this outcome. Looking ahead, policy adjustments will depend on the implications of incoming data for the projected paths of economic activity and inflation. I must admit I am surprised at how little market participants seem to share my sense that the uncertainties around these paths and their implications for the stance of policy are fairly sizable at this point, judging by the very low level of implied volatilities in the interest rate markets."

This came in his conclusion where he was talking explicitly about his view on monetary policy. So he seems to think that the next move by the Fed could be in either direction, and he is surprised to see the market trade so one-sided.

Philadelphia Fed President Charles Plosser also spoke today in Philadelphia. This speech seems to be focused on giving his general views on monetary policy, and is focused on the primacy of price stability. Plosser is new to the Fed, having come on in August. He sounds like a real hawk, but don't they all?

Anyway, anyone who thinks the Fed will cut just because GDP growth slows slightly should read this speech. Particularly quotes like this:

"The fact is that economists have had a very difficult time identifying any reliable and exploitable link between monetary policy actions and real output or employment in the short run either. Policymakers have neither the knowledge nor the tools to manage aggregate demand with the timing and precision necessary to neutralize the impact of unexpected shocks on output or employment."

Or this (emphasis is in the original):

"...if a negative productivity shock causes potential economic growth to slow, then market interest rates will tend to fall. So, again, as long as inflation is at an acceptable level, the Fed would want to reduce the federal funds rate as well, to facilitate this adjustment of output growth to a rate consistent with the new economic fundamentals and, maintain price stability. Failing to do so would again result in a misallocation of resources and possibly deflation."

So what's he saying? That cutting rates to stimulate growth isn't particularly effective. That rate cuts can only come at a time when to do otherwise might risk deflation. As to his opinion on the current situation?

"Assessing our current circumstance against my three principles of sound monetary policy, I find three things to be true. First, there is a significant possibility that inflation rates will remain above those consistent with price stability for some time. Second, this prolonged period of relatively high inflation runs the risk of undermining public confidence in our commitment to price stability, thereby raising the cost to the economy of restoring price stability. Third, sectoral adjustments not withstanding, the overall economy is likely to return to its potential growth rate in 2007."

Mmmmm... don't see any rate cuts anywhere in that paragraph.

Still think the Treasury market is ahead of itself. Today's sell off, 3/8 on 10's, just erases yesterday. It doesn't change the picture.

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