The Fed's Dilemma

The Fed will either keep rates steady or hike by 25 BPs at this week's FOMC Meeting -- and either has problematical implications for the markets.  Keeping rates steady would suggest the banking issue is indeed serious.  Or, the policy could be viewed as inflationary.  Hiking by 25 BPs could be justified by saying the Fed addressed the banking problem with a different tool -- guaranteeing deposits.  But, a hike would raise concerns that it would exacerbate the banking situation, even if the latter was not viewed to be serious enough to force the Fed to pause in its anti-inflation fight, and raise the risk of recession.  It's not clear which policy choice would be the less costly decision for the economy or markets.  

The markets also will pay attention to the updated Fed's Central Tendency forecasts.  The forecasts, however, may have been made too early to take account of the banking problems.  Regardless, some considerations argue for little change in the new forecasts.  A slowdown in inflation and economic growth are still reasonable expectations. 

The inflation picture, indeed, may be better than most think.  Housing rent may be the main reason why the CPI is running above the Fed's 2% target.  The Core CPI Excluding Shelter has been down to a pace consistent with the target since October, rising 0.1-0.2% on a m/m basis in each of these five months. (see chart below).  Housing rent is a lagging indicator and so far has not captured the rent declines seen in private surveys.  It is expected to catch up in the second half of the year.   

Besides prospects of a rent-led slowdown in inflation ahead, economic growth risks slowing into the Spring.  The unusually warm winter likely was responsible for some of the strength seen in January and February -- as reflected in the Atlanta Fed model's above-trend 3.2% estimate of Q123 Real GDP Growth.  The warmth probably pulled ahead spending that would normally be seen as the weather improved in the Spring.  Payback should be a drag in March and into the Spring as temperatures revert to normal levels. 

Some Street Economists point out that the banking problems could result in more restrictive lending practices and damage consumer confidence, thereby hurting economic activity.  This is not the full story, however.  The fall-out also includes sharply lower long-term yields and oil prices.  Mortgage rates should come down, helping housing demand.  And, lower oil prices should boost consumer purchasing power.  So, a recession is not necessarily a consequence of the current financial crisis.

The decline in oil prices is probably a significant difference from the 2008 episode.  Then, oil prices surged to $145/bbl and "killed" the consumer.  My view is that the Fed made several major mistakes that year, one of which was viewing the banking crisis as a liquidity problem rather than a confidence problem among banks, which, in fact, it was.  By cutting rates sharply (to increase liquidity) the banking confidence problem was not solved but commodity prices, including oil, surged.  The drop in oil prices now is one of a number of reasons why 2008 is not a good analogy and why a recession ahead is not a foregone conclusion.