• We are now convinced that the Federal Reserve is going to tighten through year-end and into 2006, and we have raised our funds forecast from 4% to a peak of 4.5%. We’ve done so even though we think that inflation worries are overdone. Moreover, because of that view, we are not turning bearish on long-term bonds.
• The recently released FOMC minutes were on the hawkish side, and we certainly did notice the plural in the comment “further rate increases probably would be required” to “contain inflationary pressures.” The Fed sees Katrina’s effect as temporary when it comes to growth, but longer-lasting when it comes to underlying inflation. The minutes were also sprinkled with concerns about fiscal policy and its inflationary implications. In addition, Fed staff economists raised their forecast of both growth and core inflation for 2006 (the former reflecting the rebuilding effort, the latter reflecting the spillover from higher energy prices).
• Almost a year ago, we published a report that acknowledged that we may be too light on our Fed funds forecast. We went back over the past three decades to see what the market and macro landscape looked like when the Fed was done tightening, and we came up with a checklist. So far, only two of the 10 indicators on that list are in areas that, in the past, pushed the Fed to the sidelines; the yield curve is very flat, and the VIX is 60% above its low. Three more indications are headed in that direction: retail sales need to be flat-to-down for two months (but the data have to be clean), industrial production has to be flat-to-negative for three months, and commodity prices need to have peaked or rolled over. The jury is still out on the other five indicators: non-farm payroll gains below 100,000 for three months, the ISM index at 50 or less, real GDP growth below 3% for two quarter or more, Baa credit spreads around 50 basis points, and the stock market down by about 15%.
• Any central bank that can hike rates – and hint at further increases – after an unprecedented two-month 20-point slide in consumer sentiment obviously has a long list of concerns. Among them are the excesses in the housing and mortgage market, investors’ complacency about risk, fiscal largesse, the pass-through of high energy costs to core inflation, rising unit labor costs, heightened inflation expectations, tightening labor markets, and the possibility that the output gap has closed.
• Perhaps the timing of Chairman Greenspan’s retirement is also playing a role in the Fed’s unwillingness to pause. That is pure conjecture, but it may be that Mr. Greenspan wants to defend his reputation as an inflation-slayer and eliminate the term “Greenspan put” from the investment lexicon. Another point: the impending change at the helm of the Fed may be adding to the prospect that more tightening lies ahead. How? The record shows that a new chairman follows his predecessor’s policy about 75% of the time. Or maybe—just maybe— the Fed wants to be out of the picture by the time Congress hits the campaign trail for the 2006 elections; if that is so, it would mean that the Fed would do more now rather than later.
• Our Taylor Rule model says that a funds rate of 3.5% is justified now in view of the size of the output gap, core inflation, and real interest-rate proxies. Even so, the Fed has already gone beyond that and is moving into the same “overshoot” territory that it reached in the past. In fact, the historical record shows that the Fed has typically overshot neutral by 200 basis points, based on the funds-rate peak benchmarked against our fair-value Taylor Rule estimate. We cannot see how the inflation or growth picture gives the Fed any reason to go that far.
• It may be that today’s potent combination of factors—the housing market’s “froth,” the bond market’s “conundrum,” fiscal concerns, the current-account deficit, Katrina-related stimulus, and the potential that high energy costs will feed through to general inflation—means that monetary policy has to look beyond the classic Taylor Rule. After all, the Taylor Rule relies heavily on the output gap estimate, which Fed Governor Kohn basically said was no longer a particularly reliable predictor of inflation. Overshoot? Inversion? Could Be.
• With that in mind, we may have to consider the possibility that a classic overshoot is in the cards. That is not to be taken lightly. In our view, it would necessarily entail an inversion of the yield curve. During the past three decades, the Fed has tightened on eight occasions, and when it did, the yield curve inverted five times. Each time there was an inversion, the economy fell into a recession. We would recommend watching the two-to-five-year part of the Treasury curve; in the past, it has shown an uncanny ability to lead the entire curve into an inversion. Right now, it is only a few basis points away.
• The risks that would spring from a policy mistake are not trivial. However, it almost sounds as if Mr. Greenspan is ready to accept those risks. Recall what he said in his closing remarks at Jackson Hole in August: “Surely difficult times lie ahead for the Fed, some undoubtedly of our own making, and others that will be thrust on us by market or other forces” [emphasis added]. By the time we see the “thrust,” most or all of the 10 conditions on our Fed checklist will probably have been met. The question is when. The answer, at least for now, is the first quarter of 2006.
David Rosenberg
North American Economist, MLPF&S
