Wednesday, October 11, 2006

Minutes and Lacker

The minutes of the September 20 FOMC meeting were released today. In my opinion, there isn't much here that wasn't already said in recent Fed Head speeches. Bottom line: inflation is too high, but may subside on its own from here, both because of economic weakness and the cumulative effect of rate hikes heretofore. The market took it as bad news, as the 10-year is currently down 6 ticks on the day, when it had been up as much as 1/4.

Richmond Fed President Jeffery Lacker spoke in Washington earlier today. Worth mentioning that he spoke a little about his rational for his dissent at the last two FOMC meetings.

On housing:

"Many macroeconomic analysts are concerned about the potential fallout of a weakening housing market. The direct impact of the housing market on overall economic activity is easy to calculate. The measure of residential investment spending that is included in real GDP has now fallen for three consecutive quarters. In the second quarter it fell at an annual rate of 11.1 percent, and appears likely to decline even more rapidly in the second half of this year. Since residential investment accounts for less than 6 percent of GDP, that lowered the real GDP growth rate by about seven-tenths of 1 percent in the second quarter. It would not be surprising to see housing reduce growth by even more for a few quarters. That would be a significant drag on the economy, but it would not end the expansion either, especially in light of offsetting strength in business investment spending..."

So if he has a more sanguine view of the housing market and its impact on economic growth, it makes sense that he'd reject the notion that upcoming weakness would allow inflation to decline. I think housing is a pretty big deal, as I've mentioned before. I think a significant decline in home prices could very well lead to a recession. My thinking on housing is that it will look more like several years of soft prices rather than a crash. Its the crash scenario which causes a recession.

Later, he hits the point more directly:

"Moreover, the longer inflation remains elevated, the more difficult it will be to bring it back down. As people observe actual core inflation of 2.5 percent, along with the FOMC’s reactions, they adjust expectations regarding future inflation, and those expectations become the basis for price setting in product and labor markets. (By the way, it was for his contributions to economic research on exactly this phenomenon that Professor Edmund Phelps was awarded the Nobel Prize in economics a few days ago.) If the Fed were to allow inflation to remain above target for too long, inflation expectations could become centered around the higher rate. Once that occurs, history tells us that strong and more costly policy actions would be needed to bring inflation and inflation expectations back down. We don’t have any perfect measures of inflation expectations, but what we do have suggests that market participants do not foresee a rapid fall in core inflation. This is why I have argued for further policy actions to convincingly restore price stability."

Again, nothing terribly new here, but its another FOMC voting member saying that they are unwilling to allow current inflation levels to become expected inflation levels. Basically he's saying he'd rather be safe than sorry on inflation, and he's not convinced that the weakness everyone sees is going to come to fruition.