Monday, September 10, 2007

Is 25 symbolic? 

I haven't commented for a few days on the situation with monetary policy (I'm writing a paper for this conference, and I was well behind schedule), but the commentary around the blogosphere has been really good, so it isn't like you missed much. But I have an opinion, as the title suggests.

As I've noted (and those in the post as well), the Fed has operated in the repurchase market to allow the interest rate to be well below its target of 5.25%. James Hamilton, who has been the one noting this stealth easing, writes this morning,

At least the fed funds futures markets stood up and took notice of the employment report, with contracts on Friday predicting 4.94% for the month of September-- that's 6 basis points lower than on Thursday-- and 4.58% for November-- down 12 basis points in a single day, and suggesting a likely cut in the fed funds target of 75 basis points over the next two meetings. Apparently there were even rumors that the Fed would implement an intermeeting cut by 2:00 p.m. EDT last Friday.

First, there's little doubt that the employment report was negative, as much for the revisions to June and July figures as for the August report of a loss of 4,000 jobs. Try the government will to polish the turd, but when your revisions take out an extra 80,000 of job creation, well, that's just not going to work for most of us.

Now, revisions to previous data are almost always a surprise. Prof. Hamilton has been using a weighted average of the household and payroll surveys plus the ADP employment report, with the household survey telling us a whopping 316,000 jobs lost. But I believe the Fed has already taken note of these. In its open market operations last Thursday it issued $7 billion in 14-day repos and $16b in 7-day repos. Demand for these were unchanged from the previous week. The H.4.1 report showed an increase in reserves of $6.6 billion last week. Now some of that is normal for putting in credit for Labor Day weekend, but it doesn't appear much came back out.

So I think the stealth easing has continued, and the actual Fed Funds rate will stay closer to 5% than the target 5.25% through to the meeting on Sept. 18.

The Fed has already said that "downside risks have increased appreciably" in an inter-meeting statement that does not include the word 'inflation' anywhere. The Fed will still get some information on inflation over the next week, with the PPI out on the morning of the first day of the meeting and CPI the next day. Let's suppose those two reports show quieting on the inflation front. Would a 25 basis point reduction in the Fed funds target be enough? If they were to cut 50, would Tim Duy be right that "this is the moment the tide turned on the 25+ year battle against inflation"?

I have been wrestling with that question myself. There are two things working against the Fed. First, it continues to operate under a dual mandate in the Federal Reserve Act that makes it pay attention to movements in the real economy, unlike the ECB's sole mandate for price stability. It has to give testimony to Congress about meeting those two goals. (While my own preference would be for a sole mandate for price stability, we won't have that until someone changes the law.) The paper I am writing for the conference included a review of that literature as well as a statement about the relationship between price and financial stability. In the long run, price stability provides for financial stability because it allows investors and borrowers to not be surprised in their debt contracts so that one of the two suffer losses. In the short run financial stability may threaten price stability, but if the instruments through which we provide for the former do not include inflating the money stock price stability may be maintained. Bernanke argued this himself last January.

So the financial stability question doesn't bother me so much. The Fed, though, has never been permitted to abandon its second mandate for high employment and growth, and is unlikely to do so now. And that is why, if the results of the inflation reports are mild, I wonder if 25 will be enough? I actually suspect not. I think the discussion that the Fed is being dragged "kicking and screaming" to a rate cut is premature. I would not be surprised by a 50bp cut, even with two or three dissenting votes (which would be above average, and not unusual for bank presidents to vote for tighter policy than the Board does. See Ellen Meade, for example.)

The news of the week and early next will tell us. I wouldn't put my chips down on a particular cut just yet.