By Karl Smith
New York Fed President Dudley said recently
While these developments are certainly encouraging, it is far too soon to conclude that we are out of the woods. To begin with, the economic data looked brighter at this point in 2010 and again in 2011, only to fade as we got into the second and third quarters of those years.1 Moreover, the United States has experienced unusually mild weather over the past few months, with the number of heating degree days in January and February about 17 percent below the average of the preceding five years. While this reduces the amount that households and businesses must spend for heating, I suspect that it temporarily boosts economic activity overall. For example, the mild weather is certainly conducive to higher than normal levels of construction activity, and we did see a surge in hours worked in that sector over the past few months.
Dudley didn’t make this fully clear, but the direct effect of less home heating is that Personal Consumption Expenditures fall – this is where utility bills go in GDP – and that Industrial Production and Capacity Utilization fall as utility output counts towards these totals.
His suggestion is that this is overwhelmed by increases in residential construction and other factors, so that the net effect of mild weather is larger measured economic output.
I am not actually sure which way it goes because the drops in the utility portion of PCE were dramatic and the increases in construction activity were not that far off what I would have guessed otherwise. Single Family starts were surprisingly strong, but builder confidence was surprisingly strong as well.
Mutli-family seems to be evolving more or less as expected, maybe a little slower. In any case, I do want to make the point that emphasizing these factors is in-and-of-itself counterproductive for the dovish Fed policy that Dudley likely supports.
It may seem that downplaying the economy’s strength supports a more dovish policy stance. However, that is not what is important to communicate. What’s important to communicate is the Fed’s reaction function and emphasizing a weak economy makes it harder to emphasize a loose reaction function.
Well, imagine if Dudley said the economy is booming, housing starts are moving in the right direction and unemployment is coming down. Nonetheless, I think the low levels of total employment in the economy are likely to warrant an exceptionally low level for the federal funds rate until at least late 2014.
This tells you that look, even if the economy is growing strongly, the New York Fed President still doesn’t want to raise rates for a while. So, that means my estimation of the path of the funds rate should fall in all cases.
I shouldn’t respond to exceptionally good data by thinking the Fed will tighten and I should respond to weak data by thinking the Fed will stay loose longer. That, market participants come to believe this is loosening of Fed policy.
However, if you imply that the only reason you want loose policy is because you expect the economy to do poorly then that could in fact tighten Fed policy.
Perhaps, Dudley is entering into higher dimensional chess where he is attempting to tilt the FOMC towards a more accommodative stance and signal to the market that the FOMC is out of touch with reality and overly pessimistic.
I am extremely wary of these types of moves and think you can easily overestimate the sophistication of market participants.
It could simply be the case that this is Dudley view and he is sticking to it. In which case I can’t fault him for that. It is simply unfortunate that he is not in a position to stake out a more dovish stance.