FOMC Preview: Bernanke’s Third Press Conference
It is great fun to be a Fed pundit!
Regular readers know that I have generally supported Fed policy, while criticizing the explanations and communications.
More importantly, we should all be realistic. It is very important to predict Fed policy and to understand the implications. That is where you can make money. The easy trap is disagreeing with the Fed. There is a genuine policy debate, reflected by the dissenting FOMC votes.
My purpose here is to emphasize the current FOMC perspective and the likely policies. If you are among the many who disagree with what the Fed is doing, I urge you — for a few days at least — to focus on prediction and put your opinion aside.
The Trader Misperception
There is a great disparity between trader attitudes about the Fed and what the FOMC members believe they are doing. Many of the big-time econ/financial blogs are basically Fed-bashers. The arguments all have a lot of appeal to traders. They look for apparent causation and follow it until it no longer works.
Please note: I am not suggesting that traders are dumb. Far from it. My teammates at the options exchange (CBOE) included many of the smartest people I have known as well as some "savants." Successful trading often involves simple heuristics. Cerebral guys with thoughtful analysis of causal models? They need not apply for the pits!
Getting it right involves a combination of understanding and speed. With that in mind….
Traders are basically wrong on three fronts:
- They are too bearish on the economy, a viewpoint widely held for years as they have fought what they call a "sucker's rally."
- They overestimated the immediate impact of Fed action in QEII and underestimated earnings, which have been very strong.
- They take Fed statements out of context, creating an illusion of incompetence. (Well, maybe exaggerated incompetence).
To do this objectively, we should consider the data that will be in front of the FOMC. I like the chart package from the St. Louis Fed. These charts highlight the data series used by the NBER in doing recession dating. They look for a downtrend, and then date the start of the recession to the last peak. With that in mind, what would be your conclusions?
I hope that everyone can see a clear pattern of growth — but weakness compared to the normal recovery.
Turning to QE II, there is a clear disparity between any logical economic effect and what traders believe.
The actual economic effects — pretty marginal — came from an expansion of the monetary base and the effect on M2. Traders, without any causal explanation at all, thought that Fed Treasury purchases somehow went directly into the purchase of commodities and stocks. The most popular financial blog has propagated this fallacy, resulting in something of a self-fulfilling prophecy. Hedge fund guys tried to game the Fed's open market operations.
For those readers who really want to understand this, check out the many links here.
To highlight this disparity I suggested a question in the most recent Kauffman poll of economic bloggers. Here is the result:
Putting aside the question of who is right or wrong, I want to emphasize the opinion of this group — the best I can do to get some real economists to weigh in. In general, they are completely uninterested in trader misperceptions!
The final aspect of trader misperception relates to Bernanke's ill-advised comments in his Sixty Minutes interview. Let me try to summarize this in clear terms:
- Bernanke and the Fed talk about small marginal impacts — higher stock prices, the wealth effect, etc. They are looking for affirmation that their message has been understood, that they have communicated effectively. If you read the actual reports about the expected impact of QE II, the forecast was for 20 basis points or so in the ten-year note. This was supposed to lower mortgage rates and provide a small nudge to stocks versus bonds, leading to an even smaller wealth effect.
- The Fed sees a continuing effect from their large balance sheet.
The Fed does not seem to have anyone on staff who is actually reading the financial media. When they barely mention a wealth effect, the financial punditry concludes that they are trying to goose stock prices, perhaps even by direct buying. The FOMC is so out of touch that they do not address this problem. Bernanke acts like he is conducting a Princeton seminar.
What does this mean for Fed policy?
In general, I do not expect any surprises. Here is the biggest thing to watch.
The Fed is edging in the direction of targeting nominal gross domestic product (NGDP). This means that in the inflation/employment dual mandate, the Fed should emphasize a specific growth target in nominal GDP.
The NGDP concept has gotten a lot of mainstream buzz, but I was still surprised at the recognition from the Kauffman bloggers.
This is a clear warning to the bearish pundits who think that inflation and/or stagflation is a problem. The Fed does not agree with the rogue economist who thinks inflation is 17% or so (and neither do other responsible economists). They see the economy as growing below trend, and they are looking for ways to address this problem.
Those who think that the Fed is out of ammunition may well be surprised.
Meanwhile, I am not expecting a specific decision about NDGP or QE III, but a message hinting at these possibilities would not be a surprise.
This concept has gained a lot of recent support.
I think that the actual decisions will be bullish, but I am not confident about the communication.
A side note: There will be conspiracy buffs who think that the FOMC action has something to do with Friday's employment report, but they will be wrong. The FOMC gets a preliminary look on Thursday morning, and the result would not really determine their action anyway.