Should We Take the Fed at Their Word?

On Wednesday I posted a poll on when the Fed would make its first hike. So far about half of the responses have been “After September 2010” with the other half being mostly between April and September.

Let’s go over my view for what will drive the Fed’s decision. If we look at the last Fed statement, the key new section is the following (its in the 3rd paragraph):

“The Committee … continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

The bold section is new, and if taken at face value, it tells you exactly what the Fed considers the sign posts for higher rates. Inflation. Nothing else.

Notably absent is employment, home prices, the dollar and anything related to the carry trade.
If take the Fed at its word then you can’t possibly expect any rate hike until the end of 2010 if not well into 2011. In other words, some time period far enough into the future to make it difficult to see. We have so much slack right now that it would take tremendous growth to close the gap. If you start where GDP was at the beginning of 2008 and assumed potential GDP was 3%, we’re currently about 7.7% below potential. Hell, my version of the Taylor Rule says we need -3.13% Fed funds right now. The Fed doesn’t have to wait for us to close that output gap entirely, but you aren’t likely to see any inflation until it gets much closer to zero.

So the question is should we take the Fed at their word? Are they worried about employment and/or the carry trade? I don’t know the answer. I’m going to be intently reading upcoming Fed speeches to see if these other factors are mentioned and in what context. I believe the Fed is going to be increasingly conscious of explaining their monetary stance. Take high unemployment. I’d expect this to get some play in most FOMC speeches, but it depends on the context. If the speaker explains why unemployment is a secondary concern to inflation, then I think we should likewise pay less attention to employment-related statistics.

I’m more worried about the carry trade and its potential for creating distortions. If those distortions are dealt with near-term, then I think the pain would be marginal. If we wait a year to do anything about it, then I’m very concerned. I don’t think circumstances warrant a hike right now per se, but I want to see the Fed acknowledge the risk. And I need more than just Fisher and Plosser talking about it (by the way, neither are voting FOMC members currently). I want to hear everyone discuss the risk. They can’t ignore the fact that excess money creation can flow places other than consumer goods, and therefore monetary stimulus can cause asset inflation.

For what its worth, I think the Fed considers bringing down their balance sheet as a bigger priority than altering rates. This is my impression from taking the mosaic of Fed interviews and speeches I’ve heard in the last couple months. That view reiterates the idea that short-term rates remain low for a long time, but it brings into question what happens to other assets, especially long-term Treasuries. The Fed bought 23.5% of Treasuries issued in 2009. In 2010, it is projected that the budget deficit will ease somewhat, but it will still be sharply negative. I think Treasury issuance rises. So with out the Fed buying, don’t intermediate-term rates almost have to rise?