Tim Duy Weighs in on What the Fed Might Do Next

Tim Duy, economics professor at the University of Oregon, posts from time to time on Mark Thoma’s blog, Economist’s View, and Fed watching is one of his favorite topics. His latest, “The Fed’s Next Move,” is particularly thorough and cogent.

He goes through the case for further rate cuts and finds the consensus view, that more reductions are in the offing, to be well founded. He believes that the Fed “is no longer confident it can disentangle housing from financial markets” and therefore will give the housing market considerable weight in its decisions. He then argues that this posture is futile, since cuts won’t restore the bubble mentality of faith in ever-rising prices. But deteriorating housing and falling inflation (if you believe those “core” CPI and PPI stats) give a thumb’s up to further cuts. He then goes through the caveats (he doesn’t buy the view that inflation is tame, but he also discounts hawkish statements by Fed bank presidents).

The foregoing is all very much worth reading in long form, but here is the doozy:

For my part, I am concerned that the Fed appears to have written off the dollar. My concern stems from rising international tensions – the Fed is dumping additional liquidity into the system at a time when most central banks are attempting to turn off the faucet. The Fed is implicitly, if not explicitly, relying on countries with fixed exchange rates to absorb that additional liquidity at the cost of inflation in those economies. Moreover, those economies with floating rates become the anti-Dollar bets, forcing the Euro area, Canada, the UK, etc, to be the deflationary counterweights to the inflationary US policy.

Is it a surprise that the ECB is under pressure to support the Euro with a rate cut? The only surprise is that there is not more chatter about an ECB intervention if only to erase the idea buying the Euro is a one way bet.

In my darker moments, I fear that the Fed is forcing their foreign counterparts down one of two paths – either central banks with appreciating currencies throw in the towel and match Fed rate cuts, thereby unleashing a fresh wave of global liquidity, or central banks with fixed exchange rate finally decide that they can no longer bear the inflationary cost of supporting the US current account deficit.

Adding to my concerns is that the Fed is overestimating the downside risk to the economy. Certainly, the past correlation between housing downturns and recessions is nothing to ignore. But too many indicators are not consistent with a recession for me to be embrace a dark outlook. Why are initial unemployment claims flat? Why does the consumer appear to have momentum in the 3Q07? Why are readings on manufacturing activity not solidly on the decline? Why did the inventory to sales ratio slide back to its lows? Why does the Baltic Dry Index continue to reach new highs? Why isn’t faltering demand undercutting support for oil prices?

Bottom Line: The housing down / inflation down data flow gives the Fed room to continue cutting on the basis of forecast uncertainty. Presumably, strong data would undermine the case for additional cuts, leaving me wary of blow out ISM and employment reports. There is a risk that the Fed did intend the September move to be a “one and done” action, but unless they want to get into the habit of surprising financial markets, they need to make that clear – or the data need to be strong enough to do it for them.

I think the reason that the economic figures still look solid is 1) some of them do not correspond with reality (per Duy’s discussion of inflation earlier in his post) and 2) consumer spending is up in part due to inflation rather than unit growth, and in part due to reluctance to curtail their lifestyle. Spending will hold up only as long as they have access to credit. As the home equity lines begin to be tapped out, or consumer confidence takes more of a beating (which will reduce their inclination to borrow), you will see the slowdown take hold.