Tales of the Liquidity Bubble

Yes, today's title is a bit of a stretch, but there's no point in stopping the momentum that has been built up so far this week - not with the potential for story telling that may result from the release of today's policy statement from the Federal Reserve.

While everyone is expecting another quarter point hike to short-term rates, it is the words contained in the accompanying policy statement that will weigh on markets today. In the aftermath of last month's FOMC meeting and the ensuing Bartiroma-gate "misunderstanding", anticipation is at an all-time high waiting to hear the tone of the text.

Perhaps after what happened last month, the new Federal Reserve Board would be better served this month by recycling a few words from the last Fed chief in an attempt to return a sense of normalcy.

Maybe some Alan Greenspan-style obfuscation is in order. Searching the archives at ThinkExist.com reveals a number of possibilities.

“The more flexible an economy, the greater its ability to self-correct in response to inevitable, often unanticipated, disturbances and thus to contain the size and consequences of cyclical imbalances.”

“It is important to remember that most adjustment of a market imbalance is well under way before the imbalance becomes widely identified as a problem”

“... the flexibility of our market-driven economy has allowed us, thus far, to weather reasonably well the steep rise in spot and futures prices for crude oil and natural gas that we have experienced over the past two years,”

“Look at it! Look at it, damn you! This is the result of your consistent, persistent, grinding, impoverishing inflation, you despicable loathsome morons!”

[That last one actually did show up as an Alan Greenspan quote, though it's hard to believe these are the words of the departed Maestro]

Inside Ben's Head

So what might be going on inside Ben Bernanke's mostly bare cranium? That is, mostly bare on the outside - there's no doubt that Ben is a pretty smart fellow. What might he be thinking as he ponders his selection of words?

It's clear that he wants to be able to stop raising rates sometime soon, and be able to resume the rate increases or begin cutting interest rates, as necessary, sometime in the future,based on incoming data. But the markets don't really like that kind of uncertainty.

What are the markets expecting him to do?

According to David Altig's excellent Macroblog, based on options on federal funds futures, the markets are expecting a pause through August as depicted in the charts below.
Of course, as David points out, this is subject to change - daily. This is best demonstrated by the "pincer pattern" in the June Meeting Outcomes chart above. (It's either a "pincer pattern" or one of those drawings where successively larger fishes are about to eat each other).

The Pause that Refreshes: The arguments to pause are fairly clear - it's avoiding that whole "running into a ditch" scenario that board members commented on with the release of the Fed meeting minutes from 2000 - when the Greenspan crew hiked rates a half a point in May of that year after the stock market had already peaked.

Everyone remembers what followed that rate hike and nobody wants a repeat (or even a rhyme, for that matter). The delayed effects of monetary policy make steering this huge economy quite difficult as Ben well knows. He once remarked that monetary policy is like tuning up a car while it's speeding along at 60 mph.

It's not clear if the "running into a ditch" analogy was in any way related to the "60 mph tune-up" analogy.

As there is generally a six to nine month lag between monetary policy actions and their impact on the economy, it is easy to make the argument that after the hike today, they should just sit there at the nice round number of five, and see what happens.

Increasing accounts of trouble in the housing market should add credence to this point of view, since in many once-hot real estate markets the wheels appear to be coming off rather quickly - just the increase to five percent this month will prompt objections from an increasingly unpopular Congress, from an increasingly "squeezed" electorate.

Americans have gotten used to inexpensive debt, and lots of it.

Don't Stop Now: On the other side of the debate, the arguments to keep raising rates are less compelling. Core inflation is still around two percent and inflation expectations are still well contained - how these statements relate to rising prices experienced by American consumers is, of course, not well understood and apparently of little importance in making monetary policy.

The rising costs of raw materials, the product of what CNBC is calling a "commodity bubble" that is apparently ogling peoples necklines, have not yet fed through into consumer prices as measured by the core CPI or core PCE, and if it's not in the core it doesn't count.

Economic reports have been good lately but the disappointing labor report from last Friday (nonfarm payrolls of 138,000 after expectations of almost 200,000) should provide sufficient grounds to go easy on future American debt service.

What else might influence Ben Bernanke and the board? Gold? The Dollar?

If the yellow metal weren't so darned irrelevant then maybe gold price charts that are going vertical might make a difference, but $500, $600, $700, $800? It just doesn't matter. No one pays attention to gold anymore, there are many other much better indicators for formulating monetary policy.

And as for the U.S. Dollar - the rest of the world will love us and our currency no matter what we do.

Maybe the best thing for the Fed to do at this point, given the events of the last few weeks, is to reverse course on the "openness" pledge that began the Bernanke era, and do what many companies now do - provide no guidance at all.