Tuesday, January 02, 2007

The Fed's Market Expectations Squeeze

Interesting to see the prognostications on various sides of this now-I'm-up, now-I'm-down economy. They change from week to week.

For example, today a Bloomberg article by Deborah Finestone quotes several sources as believing the Fed will lower interest rates in 2007. Just prior to that, the speculators were saying the Fed would probably not lower interest rates in 2007.

I have no idea how they come to either conclusion. As a skeptical economist-gadfly, I know there exists no method for figuring out what the Federal Reserve will do during the next 356 days, because: (1) we don't yet have in hand the statistics they use; (2) we don't know how they will interpret those stats; and (3) the Fed regulators themselves don't know what they would do even if they did have the figures and the interpretations.

But gamblers being gamblers, the setters of odds are waxing and waning, and now waxing again, that the Fed will relax it's grip on interest rates in 2007.

If the Fed does this -- i.e. if they lower the target Fed rate from 5.25 to, say, 4.75 as one spokesman expects, they will be loosening the credit spigot again and encourage more dollar liquidity.

Now, this might help strapped mortgagees and keep housing prices from falling sharply; but what will it do for the dollar? In other words, what pressure would this place on the foreign exchange evaluation of the dollar?

Yes, you have figured out that it will add pressure to lower it. And guess what? The exchange futures market has also expected this: The dollar just slipped another notch back down to $1.33 a euro, to cite only one alternate currency.

In coming to their action decisions, the Fed members state that they look at the stats. They also look at the markets for some input. (See my previous post for a more detailed explanation coming from one of their members.)

But ... doesn't that mean that the market is watching the Fed, and the Fed is watching the market?

Yes it does. And because both sides are observing each other, the Fed has what they themselves have called a "mirror problem," i.e. while they are looking at the market for signals of where the economy will go and what the players expect, they find that the market is looking right back at the Fed for signs of what it's own future actions will be.

Disconcerting, to be looking at someone and realize that you're looking at yourself.

So the market will continue to attempt to outguess the Fed, and the Fed will have the choice of going along with market expectations or of disappointing market expectations. Which will they choose?

Either way, the amount of money in play is staggering. I hope the Fed is getting good at Market-Squeeze Poker.

[Thanks to lilligren.com for the photo -- a composite, surely.]


Anonymous John Fleming said...

I completely join your mirror view and I would add that it seems that both sides are just waiting until the mirror ... cracks?
How can you fight so much liquidity an inverted yield curve save housing, a US growth-economy, banks, pension funds and all that at the same time. Something has to give, but nobody wants to pull the trigger. The tsunami-alert is given, we just don't know which shores will be swept away.

7:45 AM  

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