Monday, August 4, 2008

When Doves Cry

Events bury doves: The Fed Hawks have the upper hand. The balance has been shifting. The reason is clear. After the aggressive rate cuts early in the year market rates began to rise instead of fall. At that it became clear that further rate cuts would not be helpful and in fact had become harmful. It was as though the doves had scored a basket for the wrong team.

Hawks circle: The main reason for the hawks to have gotten the upper hand was that the doves had no strategy once rate cutting stopped working.

Facts favor hawks: As oil prices continued to spiral higher in 2008; headline inflation soared too. Core inflation stayed more or less tranquil but it came to show a bit more pressure than the Fed has wanted, as it ahas informally desired core PCE inflation at 'no more than' 2%. In this circumstance the hawks gained more strength. As of June the Core PCE is rising 2.3% Yr/Yr. The Core CPI is up by 2.4% Yr/Yr. As the CPI generally rises by 0.4% per yr faster than the PCE, its range tops out at 2.4%. So the CPI is at the border of acceptability in terms of its inflation pace but the PCE core is excessive as its top is at 2% and its pace at 2.3%.

A complication: These are not draconian departures from price stability as the Chairman has defined it by his ranges (which are not formal targets or accepted by the FOMC as as a committee). But with headline CPI inflation at 4.9% in June and total PCE deflator up by 4%, the Fed is concerned about its credibility. Fed credibility is what anchors inflation expectations, and that is what keeps inflation under control. Credibility may not be only abut inflation's core. Various arguments have been conjured up to blame the falling dollar on Fed policy and rising oil prices in turn on dollar weakness. So the headline inflation rate is in play as well as the core...

Doves cry but hawks are tethered:
With these developments in train the Hawks have pressed their upper hand with talk of coming rate hikes and with enough credibility to move some futures markets. Still the Fed has extended its special credit facilities into next year, an implicit acknowledgment that financial conditions remain out of kilter. And while economic conditions may not have deteriorated sharply there is evidence of some further deterioration: in car sales, in confidence, in the unemployment rate, and so on. There probably is enough of this evidence now to stay the hawks hands... or talons, as the case maybe.

That is what has the Fed in a stalemate.

The worm turns again: Economic weakness is not fading away and this too keeps the hawks at bay. It actually looks as if weakness is getting more intense. And oil prices have broken out of their dead run toward $150/bbl and are looking weaker: still high but in a downtrend. That weakness lowers the risk of continued acceleration in headline inflation and further brings the hawks to heel. While the hawks still seem to hold sway at the moment they do not hold enough firepower to get a policy change. Moreover, the events that govern policy, economic growth and inflation dynamics, seem to be shifting again, this time to favor the doves.

The passive hawk position is still activist: If the economy continues to weaken the threat to inflation will not seem so severe. Some hawks will nonetheless want to hike rates on the grounds that rates are simply too low for price stability. That is the passive hawk posture. But to execute this plan the economy will have to be stronger not in its current weakening mode.

Doves to draw to inside straight? Headline inflation will continue to be a negative for price stability for some time to come. It will take some out-sized weakness in the economy to truly keep the hawks at bay by driving down headline inflation, oil prices, and other commodity prices - all at once. But I think that is exactly where we are headed - to real recession-like weak growth, to steep job losses and to clearly worsened conditions. That will put the hawks on hold and bring the doves back into favor.

The race to November: While hawks retain the upper hand for now, they are losing their grip and have the elections closing in as an immediate rate-hiking impediment. Still, they have a long lasting desire to move rates up just because they are too low. Doves, on the other hand, have no plan. Fed financing facilities have kept the economy aloft. The economy will have to get very weak and market conditions will have to change a lot to put a rate cut as a serious option on the table. It's not clear if anyone on the Fed now fits into this category of dove - one that wants a rate cut now. At the moment it seems almost impossible that the Fed could do it. But if the economy weakens sharply, the doves could regain control and could even spread more dove-like wings, especially ahead of the elections. Stranger things have happened. And strange things do happen when they depend on the economy's performance. It should be clear that policy does not depend on dogma but instead on the fate of the economy.