The Fed Must Keep Pace with a Constantly Changing Economic Reality

Cutting 75 basis points rather than the expected 100 basis points along with strong anti-inflation language gave the Fed positive near-term reinforcement from market participants:

• Dollar went up
• Food/fuel/commodities went down
• Stocks did ok, including housing companies
• Credit did ok

But it's going to look to the Fed a bit like taking medicine: initially small doses have the desired effect, but gradually, it takes ever larger doses to remain effective.

So now crude/food is moving back up.

The US$ is moving back down.

Stocks and GDP are doing ok. Exports are booming. Existing home sales are up, new home sales have been revised up and above expectations. Mortgage purchases and refinancing applications are making a recovery. Jobless claims and continuing claims are also well below recession levels. And the fiscal package is about to kick in.

Demand is being supported by increasing net govt. fiscal spending and rising exports due to the reduced desires of non-residents to accumulate US$ financial assets.

Foreigners no longer want to accumulate a net $60 billion a month of US financial assets (negative trade gap) due to the actors on the stage screaming fire in a crowded theater of previously content patrons:

1. Paulsen calling CBs that buy US currency manipulators
2. Bush making it politically impossible for Muslim nations to further accumulate US$ reserves
3. Bernanke giving inflation a back seat to 'market functioning' via deep rate cuts into a triple negative supply shock
4. Pension funds diversifying to passive commodity and non-US equity strategies

And the Saudis continue to act as a swing producer and keep hiking prices.

Meanwhile FOMC members are commenting that food and energy prices are leaking from headline CPI to core measures and inflation expectations have begun to elevate.

For the Fed to keep moving the needle away from inflation it's going to keep needing to not give markets all they are anticipating.

So with a 25 point cut anticipated, they will realize they need to do no cut for a positive inflation response, and with no cut anticipated they need to hike, etc.

Credit markets will quickly get ahead of this and begin anticipating hikes.

The irony is higher rates will help support demand via the interest income channel. And higher rates will support price increases via the cost channel.

The jobless recovery morphed into the full employment recession, and is now showing signs of recovery.

That does not mean the issues with the financial sector are all behind us - far from it.

It does mean the real economy has figured out how to move on without the financial sector. Now the Fed has to figure out how to bring inflation down with a weak financial sector and an output gap that is too small.

Comments

[gordon:]

I am damn SICK of hearing you and the CNBC herd repeating "EXPORTS ARE BOOMING"! Why do you parrot that phrase, as if it's positive? ONLY 16% OF GDP IS EXPORTS. It kills the average American to devalue the Dollar for a MINORITY OF BIG BUSINESSES! Next, you'll parrot "TRICKLE-DOWN"! Stop the mindless media rhetoric without qualifying the meaning and consequence of your words. Small business, 70% of the IS economy DOES NOT BENEFIT FROM EXPORT SALES.

[Comment edited for abusive language. Commenter put on notice]

2008 Mar 28 01:02 PM

[vodka_tonic:]

good article. inflation was high on my list, but latest numbers suggest it is under control. recession through lower consumer spending is next on the radar. housing is still fairly screwed IMHO.

2008 Mar 28 01:49 PM

[Tony Soprano:]

Good piece Warren,

It's amazing how ingenious we Americans be!

2008 Mar 29 01:20 PM

[siresage:]

Absolutely moronic. It takes a full 18 months for the real (not psychological ) effects of a Fed reserve move to fully impact the economy. We are feeling the inflationary consequences of energy costs rising over a year ago. Any current signs of increased spending are really the increases of inflation biting into the day to day cost of living for Joe six pack. These fluctuations are meaningless in the face of a tsunami sized trend down and the Fed is only adding fuel to the fire.

2008 Mar 29 05:34 PM

[Warren B. M...:]

"I am damn SICK of hearing you and the CNBC herd repeating "EXPORTS ARE BOOMING"! Why do you parrot that phrase, as if it's positive?"

Read my bog where I've made it clear that as exports are real costs for the macro economy and imports real benefits, our rising exports are diminish our real terms of trade and our standard of living. Furthermore, export economies are characterized by low domestic demand and consumption, as there are relatively high levels of employment sustaining output, but prices and wages are such that workers can't afford to consume their own production with the difference being exported for foreign consumption.

"Absolutely moronic. It takes a full 18 months for the real (not psychological ) effects of a Fed reserve move to fully impact the economy."

All of the Central Bank studies I've seen show very little correlation between interest rates and GDP and/or inflation, and, as you say, what little they do show has lags in the 18 month range, which on average crosses a fiscal cycle.

My conclusion, until convinced otherwise, is that inflation and GDP are not functions of interest rates, but only functions of fiscal policy.

I have also repeatedly pointed out on my blog that domestic demand has been diminishing since q2 06 when the federal budget deficit became too small to allow the domestic sector to increase it's debt at rates sufficient to sustain domestic demand.

Exports came on strong and picked up the slack, sustaining output and employment, but a at very high cost to our real terms of trade and standard of living.

see moslereconomics.com

the 'mandatory readings' are on the right margin.

2008 Mar 30 03:47 PM