Tuesday, December 11, 2007

The Fed -- that's some corner you backed into 

I imagine a new Jim Cramer explosion is on the way -- Mish notes Bill Gross saying "The Fed does not understand the gravity of the situation" -- but I'm trying to figure out whether the Fed could have made this move given what they believe about inflation.

The charts on the Taylor rule suggest that inflation is under control, if you believe there is much productive capacity still in the economy. I also see inflation still being above where the Fed would like it if you look at median CPI or at TIPS data. So their posture could be seen by some as having room to come down, but not to move to a really easy position. If we assume the Fed forecasts 2% GDP growth for 2008 and thinks PCE inflation will be 1.9% (from its minutes of its prior meeting) then my forward-looking Taylor rule forecast for 2008 would be 3.75-4.00%. Maybe, just maybe, you can imagine taking that journey with a single step, but it is not the Fed's wont. Perhaps it is, as William Polley suggests, just a chance to buy some flexibility. But I would guess that, unless the Fed gets a sneak peek at Q4 GDP figures -- it meets 29/30 January, right when those data are announced -- you probably can plan on another 25 bp next month. The WSJ speculates that the lack of "insurance" language in the directive means the Fed moved down its forecast from here. The Taylor rule would provide you the best case, but I cannot get that to give me a cut much more than another 50 bp from right here. If the 4th quarter GDP number comes in negative, however, all bets are off.

Street economists are more dour. Small surprise there.

UPDATE (12/12): James Hamilton suggests that the futures market might have told you exactly a quarter-point, if you had thought it through.