Monday, August 07, 2006

I'll put $10 on "raise" 

One problem with being out of the loop was that I could not track this most interesting period in Federal Reserve policy. The market makes it about an 18% chance that the Fed increases the discount rate to 5.5% tomorrow. I know what the numbers say. I also think I have a handle on Bernanke; he is sufficiently stung by previous perceptions of being an inflation dove that he probably needs one good 'sting' of the markets to get them to pay attention to what he says rather than what they think he's going to do. I won't be surprised if the string of increases ends tomorrow, but I'm betting on the momentum instead.

Martin Feldstein agrees (subscribers link):
It is understandable that it would like to achieve the soft landing of low inflation with continued solid growth. But that may not be possible. And if the Fed wants to convince the markets that inflation will be contained in the future, it must show that it is willing to take the risk of tightening too much.
I remember that Bernanke once gave a speech when he was a governor of the Fed (before his stint at the Council) in which he discussed OLIR -- the optimal long-term inflation rate. In that he said,
the OLIR should have long-run credibility, that is, it should be the best (lowest-forecast-error) answer to the question: "What do you expect the average inflation rate in the United States to be over the ten-year period that begins (say) three years from now?"
Again, that would be only a guess, but the implied inflation rate expectation for the next five years (taken by subtracting the current five-year US Treasury bond rate from that for five-year index TIPS) is 2.59% and it stays about there for longer horizons. (From the last Fed H.15 report.) If we're pretty sure this OLIR has to sit between 1% and 2.5%, I think Feldstein is right.

This is a cautious bet, so I'm only putting down $10 -- i.e., half the beer money -- on a rise tomorrow. But still, at about 4-1 odds it's a nice opportunity. Besides which, if the Fed starts saying the economy has slowed... If I'm right, want to bet on the market's reaction? I say 'up'.