Monday September 19, 2005 - 21:13:08 GMT
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Fed Statement Uncertain, Rate Hike Likely
One of the problems with catastrophic events like Katrina and 9-11 is the emotional swings most neutral observers like myself and non-neutral risk takers like yourself experience that end up playing havoc with one's views on the markets, the economy and policy. Fair enough I have gone from thinking a pause was 50-50 proposition to thinking a rate hike is 80-20 probability in all of two weeks. I have also shifted my thinking on what the statement will look like, but with far less confidence than my current call on rates. I now think the Fed will give only the slightest of recognitions to Katrina and a potential pause in tightening. A week ago I thought if the Fed hiked, it would be compelled to issue a dovish statement. This seems less likely in the hours ahead of the FOMC than a week ago. The major change is the commitment of the White House to spend whatever it takes to rebuild the Gulf states to pre-Katrina conditions, albeit improved conditions for the most disenfranchised of those impacted by the storm. This bill could come to $200bln according to some guesstimates, and $100bln to others. Say it is $150bln, the Fed has to think unfunded government outlays for Katrina reconstruction not to mention the $5bln a month spent on the Iraq War will be too much even for a politically sensitive Fed Chairman Greenspan, who I think was told by Bush in no uncertain terms earlier this month that Katrina must be taken into account when the Fed sets policy Tuesday...i.e. please pause, thank you very much.
If Greenspan is the risk management central banker of all time, why not assume he will apply the same risk management approach to Katrina that he did to deflation? Recall the deflation rationale for easing (to 1.00% Fed funds rate) was the notion that while the risk of deflation was quite low, it was disproportionately negative for the economy that it required deliberate insurance policies in the form of ultra-low nominal and negative real short-term interest rates. But Katrina is no moral equivalent to deflation. Katrina is equally inflationary, as higher energy prices risk being passed through to wages and general price level, and recessionary, as higher energy prices reduce disposable income, hit household and firm sentiment and reduce consumption and business investment.
Moreover inflation expectations have been stirred for the first time in many months with the curve steepening, through last week anyway. It seems Katrina has potentially brought an end to the conundrum that perplexed the Fed for most of this year and last. By pausing or even elevating the risk of a pause in November might signal markets that the Fed is at risk of falling behind the inflation curve. In other words the fed would ignite more inflation expectations by appearing to have a pro-growth bias. Also the market is already talking about the more or less permanent rise in energy prices and why this necessitates a shift in focus for markets and policymakers to headline CPI (PCE) from core measures. I have noted before as it turns out Blinder did as well in Jackson Hole recently that most of the c banks that target inflation, target a headline inflation rate as opposed to a core rate (Bank of Canada the exception).
Greenspan is also aware of the Greenspan premium going away with his departure from the Fed and leaving his successor with a pro-growth bias would provide additional credibility problems for a post-Greenspan Fed and I would expect, steepen the curve even more. It is incumbent upon Greenspan to err on the side of restraint during this transition period or the hand off of Fed Chairmanship will surely be volatile...forcing a more proactive response on inflation from the incoming Chairman. Also how about Greenspan staying to the end, changing the two-day meeting to a one-day meeting to accommodate the retiring Chairman? A bit odd to say the least and furthermore the next Fed Chairman will have to go to a February "Humphrey-Hawkins" Congressional hearings without an FOMC meeting under his or her belt. So maybe I am being a bit altruistic about Greenspan's consideration of his successor.
Nevertheless, I think Greenspan owes it to his successor and financial markets to stand firm on inflation amidst rising inflation expectations by hiking and largely sticking with the previous statement rather than catering to politicians and any pro-growth inclinations by either pausing or hiking and issuing a dovish statement. Otherwise a spend-prone fiscal policy teamed with a pro-growth monetary policy could be problematic for the US economy and currency ahead.
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