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In the Ring With the Fed

Marc Chandler

There's a battle going on between the Federal Reserve and the market over the outlook for the economy and the appropriate monetary policy.

In This Corner...

The Fed's position is clear; as it expected, the economy has slowed. However, as Chairman Ben Bernanke said recently, "Outside housing and motor vehicle sectors, economic activity has, on balance, been expanding at a solid pace." The Fed suggests that weakness in housing and autos is likely to be self-correcting and, in any event, unlikely to spill over and undermine the overall economy.

Fed officials have consistently argued that the upside risks to inflation are greater than the downside risks to growth. It has maintained what is tantamount to a tightening bias since pausing in its tightening cycle near midyear. Price pressures have not continued to accelerate but remain above levels that the Fed identifies as stable. The only dissent at the FOMC meetings has come from the hawks -- namely, Richmond Fed President Jeffrey Lacker -- favoring a rate hike. No one has voted to cut rates.

Equity-market participants would seem to agree with the Fed's assessment of a soft landing. Over the past month, the S&P 500 rose 2.4%, easily outperforming European bourses, which, outside of Spain, largely fell, and Japan's Nikkei, which posted a marginal loss.

And in the Opposite Corner...

The debt and currency markets are less sanguine. Prices of various instruments seem to reflect the fear of a harder landing.

Fed funds futures and the eurodollar futures imply that the Fed will likely cut its target rate in the spring. The yield curve -- almost any way you measure it -- has become more inverted, and that historically has been a fairly consistent precursor of an economic downturn.

The dollar itself has slid over the past few weeks, the slide ecoming especially pronounced over the past week or so. On a trade-weighted basis, it has declined by nearly 4% since mid-October, and more than half of that fall has been recorded since Nov. 20.

This change in the trade-weighted measure of the dollar is tantamount to some easing of monetary conditions. Economists may differ on the exact ratio, but the 4% decline in the dollar on a trade-weighted basis is roughly the equivalent of 25 to 40 basis points of easing, if it is sustained. In effect, then, the market has eased policy for a Fed that is reluctant to do so.

It is as if the debt and currency markets are trying to give the Fed a wake-up call. They're saying the Fed historically has kept rates too low for too long and too high for too long. And the current Fed is the least experienced in modern history. Donald Kohn, the vice chairman, has more experience than everyone else on the board combined.

From the perspective of many economists, the Fed is whistling past the graveyard. To address the slowdown in 2001 and mitigate the impact of the collapse of the equity-market bubble, policymakers created another bubble in housing. That bubble has now popped, and the full extent of it is still working its way through the economy.

Many of the more pessimistic forecasts warn that housing and residential construction not only will be a headwind for the economy for the coming quarters but also will likely have a broader and deeper impact than Fed officials seem willing to recognize.

So Who Is Right?

One characteristic of the current cycle is that the market has consistently underestimated the duration and magnitude of Fed tightening. Remember how the year began "one and done" under Greenspan. There have been a number of swings in market expectations toward an early cut, only to have them reconsidered.

Another market bet that has proven wrong is the one against the U.S. consumer. We've been told that consumers are tapped out, have negative savings and have taken equity out of their homes to finance their excessive consumption. But the demise of the American consumer has been grossly exaggerated.

The key to U.S. consumption is income, and that continues to hold up fine. The latest data for October showed U.S. personal income up 5.8% year over year. The 0.4% monthly rise in October compares with an average monthly gain of 0.5% in the third quarter and 0.2% in the second quarter.

Under the Greenspan Fed, there might have been a greater chance for the FOMC to cut interest rates. After all, the maestro was criticized as being a slave to market expectations. This could be one reason why the cottage industry of Fed-watchers was decimated under his tenure, as the uncanny accuracy of the front-month Fed funds futures contract was widely appreciated.

It was not simply that the market became better at reading the Fed. Greenspan's circuitous verbal jousting, the embrace of strategic ambiguity as a matter of principle and his ad-hoc approach to the conduct of monetary policy arguably mitigated some of the other forces working toward greater transparency.

The Bernanke Fed is different. Bernanke is more comfortable with decision-making rules, as reflected in his advocacy of a formal inflation target. While the Bernanke Fed undoubtedly monitors and places weight on expectations, the chairman appears less inclined to follow the market.

If nothing else, this is one consequence of Bernanke's emphasis on greater transparency and clearer communication. There is no doubt where he stands. For the better part of the past six months, the message has been unambiguous and consistent -- not swayed by volatile and frequent pieces of economic data. Strong first-quarter GDP did not prompt a panic response, like a 50-basis-point hike, that some observers favored. Nor did the initial 1.6% third-quarter GDP -- subsequently revised to 2.2% -- cause a panic cut, like some thought necessary.

In the battle for control of U.S. monetary policy, my money is on the Fed and the equity market. The debt and currency markets are too fickle and subject to various other forces that might shape the signal that its prices are generating. However, I would not bet the farm or take the risk of ruin. In the words of the Great Communicator: Trust, but verify.