Wednesday, February 14, 2007

Market bounces after Bernanke

The market is trading as though Bernanke said something surprising. Which he didn't. The upshot is that the Fed thinks inflation is likely to subside from current levels without the need for additional rate hikes. This is because some degree of economic weakness, mostly due to a weak housing market, will put downward pressure on price growth. That being said, the Fed sees higher inflation as a bigger risk than anything else.

This has been the Fed's message, more or less unchanged, since August. Of course, over that time, the 10-year has moved between 4.99% and 4.42%, mostly on varying opinions about when the next Fed cut will be.

So is the next move a hike? Taking Bernanke's statements at face value, it would seem a hike is more likely than a cut. But I'm still not convinced. The Fed knows that housing presents the biggest risk to growth over the near term. The Fed knows that the housing market is extremely rate sensitive. While they are unwilling to cut rates to support the housing market, they may have stopped hiking a little earlier than they might have otherwise.

So that leaves them on hold for a while. But if inflation slows, the Fed will wind up tweaking policy a bit, and I still think that results in a cut or two.


Rajesh said...

Asset prices inflation is not consumer price inflation. Weakness in home prices should not be an excuse for the Federal Reserve to ignore inflationary pressures.

The same people who argued that the Federal Reserve should not address the increase home prices by raising interest rates because house prices don't affect consumer inflation are now arguing that the Fed is safe in cutting interest rates because house prices are falling.

Vivek said...

I think the argument for the above can be that you cannot know whether a bubble exists ex ante but it is quite clear ex post as it comes crashing to the ground, so you disregard the bubble until it pops and then mop it up.

I forget what Fed governor pointed to a study that showed that "leaning against a bubble"--that is raising rates in the face of a bubble may actually exacerbate the subsequent crash.

That being said, I know almost nothing of the issue, so I am commenting on someone else's rationale--not my own.

Leonardo said...


Whilst I agree with you entirely, it now does become a problem if the consumption is fueld entirely by equity withdrawal and private households' security rests entirely on the precarity of their over-extended debt.
It therefore goes to follow that rates should have risen to curb the already increasing money supply. But given that the current Chairman considers money supply indicators close to worthless...

The ulimate problem is that no Fed Chairman likes to raise rates in fear of being labelled a 'party pooper'. As was the case with Volcker in the '80s until history and hindsight removes the cloack of short term thinking that is now so entrenched in modern society.
Consequently, the eventual correction (and not necessarily stock crashes and eco recessions) is further being postponed down the line.

Todd said...

Leonardo said:

"Consequently, the eventual correction (and not necessarily stock crashes and eco recessions) is further being postponed down the line."

Yeah, Bush is passing it along for Obama to handle. Wonderful ...

Tom G. said...


My Taylor Rule calculation shows 5.25% as the right number for Fed Funds, so I really don't think the Fed is ignoring inflation. On the other hand, in the past they may have intentionally overshot in order to add credibility, knowing they could just cut once or twice soon thereafter. This time they may have stopped short of that.

Besides, if the asset bubble is indicative of too much liquidity, then that is the Fed's problem.


I remember reading the same thing about leaning against a bubble. Some argue that central banks help create bubbles by creating too much liquidity. Dallas Fed Prez Fisher all but admitted that the Fed created the housing bubble recently. But what to do after the bubble is created? I looks like the Fed decided to hike slowly but make clear this was going to be a protracted tightening cycle. This allowed the market to slowly adjust to rates. So far its working pretty well.


Can't agree with you on money supply. The Fed started paying less attention to M2, M3 and the like way back in the mid 80's. I think the general consensus is that the money supply is THE most important thing for the Fed to focus on, but that measuring the effective money supply is extremely difficult.


I have the feeling that Bush is leaving more than problem for other administrations to face. I keep hearing about something going on in Iraq?

Todd said...

Tom G. said:

"It looks like the Fed decided to hike slowly but make clear this was going to be a protracted tightening cycle. This allowed the market to slowly adjust to rates."

Tom, you're on record that you think the Fed lowers rates twice in mid to late '07. But given what you said above, are you thinking that the forthcoming '07 rate cuts are just a brief reprieve from ultimately higher rates in the years to come ?

How far out are you looking when you make such statements ? And how do your longer term views (1-2 years out) effect your short term trading ?

Tom G. said...

I think the 2-3 year direction of rates depends on forces outside the U.S. Namely, liquidity flowing from Asia. Eventually, we'll reach a more normal equilibrium, which will likely result in higher rates. How long that takes is difficult to see. Always in motion the future is.

But to answer your question more directly, my best guess is that the Fed holds rates steady for a while. I think the housing market weakness will take 3-4 years to work out. The Fed will be careful during that period. That isn't to say that they wouldn't hike if they needed to, but that they are going to be extra cautious.

As far as long-term view vs. short-term view, that sounds like a good post idea on a slow holiday Friday.