Some of the commentary regarding inflation and deflation misses the point. We are presently faced with both rising consumer price inflation and asset deflation. Not a fun combination, to say the least. It puts the FOMC into a real box. To borrow an analogy from the Bible, Greenspan ate sour grapes, and Bernanke’s teeth are set on edge.
So what does the FOMC do in such a situation? We don’t have that much history to work with, but during the ’70s, the FOMC generally loosened. Fixed income portfolios should tilt toward shorter duration, even though you are losing income, and away from the dollar. It is probably still too early to begin taking a lot of additional credit risk, but the bet is getting more attractive by the day.
Now, there are a number of commentators that can’t wait one week, and say the FOMC should act now. The economy is not like someone that you have to take to the emergency ward; one week makes little difference, and the FOMC will do better work if they are meeting each other face-to-face under normal meeting conditions, than over a conference call.
Given the present equity market distress, should we assume that the FOMC will do more than 50 basis points in January? Had you asked me last week, I would have said “no.” The political pressure is a lot higher now, so I would say yes, they will do more. It won’t help the areas under credit stress, but it will make it look like they are serious about “fixing the economy.”
We could see a move of either 75 or 100 basis points. I debate internally how good Fed funds futures are in abnormal environments like this. Under Greenspan, I sometimes felt that monetary policy had been privatized, and whatever the futures market said, the FOMC would do that. I don’t know if Bernanke has the same faith that futures traders know what the right monetary policy is. If I were a Fed Governor, I certainly would not have that confidence. Once the yield curve gets to a certain slope, the recovery will come in time. Making the curve steeper won’t make it any faster.
People are impatient, and their complaining causes the FOMC to overshoot on policy decisions. The lag that monetary policy has is significant, and the FOMC in recent years has made it even slower through their policies of incrementalism.
There are several possibilities here for the FOMC action:
- They hold firm, and don’t lower much (50 bp), because price inflation is a concern.
- They take the judgment of the futures traders, and move a full 100 bp. Or, they conclude that asset deflation is a bigger risk, and decide to make a bold statement. After all, isn’t Bernanke the guy who never wants to see the Great Depression recur, and loose monetary policy can prevent that? (I don’t think that’s right, but…)
- They split the difference, make bows to both camps in their language, and do a 75 bp cut.
The last of those seems most likely to me. I have said in the past that the FOMC is:
- Being politically forced to loosen more than they would like, and
- Dragging their heels in the process.
That’s why I think we end up on the low end of where Fed funds futures will likely point tomorrow. 75 basis points does not trip off the tongue, but will be a compromise position in the minds of Federal Reserve Governors who are puzzled at the present situation. Because of political pressure, they know that they have to move big, but consumer price inflation will make them less aggressive.