Friday, February 19, 2010

Discount Exiting & Inflation

After the stock market closed yesterday, the Fed announced it would raise its discount rate on emergency loans from 50 basis points to 75 basis points.  This move had been well floated by Bernanke and several Federal Reserve District presidents since at least the tenth of February.  If you have been listening to the radio show and/or reading the Leftover posts, this is no surprise to you.

What was unusual, but not a total surprise if you have been following the public statements of Fed officials, was the Fed funds rate was not also raised.  Traditionally, the Discount Rate and the Fed Funds Rate are raised or lowered together.  However, the minutes of the FOMC January meeting clearly indicated that the Fed Funds Rate will not be raised for an extended time, although there was dissension by Hoenig, who has been joined publicly since by Plosser.  The concern of these Fed presidents is the expectation of inflation. 

We have made it perfectly clear in the past that we think the Fed lowered interest rates too low too fast and now has three significant problems in executing an exit strategy.  First, unemployment has been used to hold inflation down, high unemployment is acknowledged as a long term reality, and interest rate increases are usually in step with improvement in employment.  Once we are twelve to eighteen months into this "jobless" technical recovery one would expect the Fed to begin raising interest rates, but this slow growth recovery will not show significant employment recovery by that time.  Second, the Fed has added significant Mortgaged Backed Assets to its balance sheet not to mention the 3 Maiden Lane funds of distressed assets, it will cease purchases in the near future with an unknown impact on the housing market, and it does not envision selling these assets for some time at a desirable price to willing buyers.  Are these on the Fed's balance sheet at a fair mark-to-market price?  They do not appear to be.  When will it be able to begin a non-disruptive sale?  Third, given the slump of Q4 2008 and the deflation that came with it, monthly CPI inflation figures should increase going forward as they have begun to do since December 2009.  This should ratchet up the expectation of inflation going forward.  Yet, it will all be in the timing and co-ordination and it cannot be expected to be perfect.  Quick recognition of a step to far or a step too slow will require decisive reaction and/or prudent retrenchment.  Let the leash out, correct undesirable behavior, pull the leash in, and then let the leash out again until the desired behavior is achieved.

Pulling back lending facilities, normalizing the discount window, the possible use of reverse repos and other means of draining reserves, such as offering depository institutions term deposits (CDs for banks) have all been discussed and are to be expected in slow increments as the water is tested.  A full exit implementation is actually a long way from the present time.  Timing the sell of Fed balance sheet assets will be difficult balancing act in and of itself, but even more difficult with long term unemployment and a growing expectation of inflation and the still precarious economy which could easily double dip or slide into stagnation.

January CPI came out this morning and close look only raises questions.  Tom Iacono has asked if there is a math problem at the Department of Labor in relation to the weighting of lodging away from home in the determination of core housing prices, which are shown as declining 2.1%.  In fact, the methodology was changed last month as stated in the December 2009 CPI release:  "Effective with the release of CPI data for January 2010 scheduled for Friday, February 19, the BLS will introduce several item structure and other publication changes into the CPI. 
"Shelter. The expenditure weight for second homes will be moved from Lodging away from home to a
new, unpriced stratum under the Owners’ equivalent rent expenditure class. As such, the expenditure
class index for Owners’ equivalent rent will now include both primary and secondary homes, and the
title of that expenditure class index will change from Owners’ equivalent rent of primary residences to
Owners’ equivalent rent of residences. Both the expenditure class (Owners’ equivalent rent of
residences), and the Owners’ equivalent rent of primary residence stratum within it, will be published.
Current Structure
Lodging away from home
  Housing at school, excluding board
  Other lodging away from home including hotels and motels
Owners’ equivalent rent of primary residence
  Owners’ equivalent rent of primary residence*
New Structure
Lodging away from home
  Housing at school, excluding board
  Other lodging away from home, including hotels and motels
Owners’ equivalent rent of residences
  Owners’ equivalent rent of primary residence
  Unsampled owners’ equivalent rent of secondary residences"

But Iacono is correct to question a change and its calculation, when it results in the first decline (.1%) in core prices since December 1982.  In fact, in the most recent January minutes of the Federal Open Market Committee, "One participant noted that core inflation had been held down in recent quarters by unusually slow increases in the price index for shelter, and that the recent behavior of core inflation might be a misleading signal of the underlying inflation trend."  The above changes would appear to have aggravated the effect.

What I found interesting in the just released CPI was Energy went up 2.8%, Energy commodities went up 4.9%, Gasoline went up 4.4%, Fuel oil went up 6.1%, and Utility natural gas went up 3.5% with all CPI-U items up only .2% for an annualized 2.63%, which is down from the 2.76% annualized rate last month.

Still, if the 1990 calculation for CPI were still being used, the annualized rate would be approximately 6.0% and, if the 1980 formula was still being used, the annualized rate would be approximately 9.9%.

Yesterday, the PPI (wholesale prices) leaped 1.4%, which was more than 3 times the December increase of .4%, on an increase of 5.1% in Energy goods.  Core PPI went up .3%.  

PPI leaped on energy increases but CPI did not.

The debate within the Fed on when to raise rates and when and how to sell mortgaged backed assets is going to become more public.


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