Nouriel Roubini is writing The Next Move by the Fed Will be a Cut, Not a Hike, as the US Slips into a Recession.

Nouriel Roubini | Aug 09, 2006

As I pointed out in my previous blog, markets and investors are behind the curve in terms of their views of what the Fed will do next. The debate and commentary among markets, bloggers and investors – based on yesterday’s FOMC statement – is still on the question of whether the Fed will keep its pause in the fall or whether – given rising inflation – it will tighten again some time in 2006. The reality is that the next move of the Fed will be an easing – i.e. a cut in the Fed Funds rate – not a tightening, most likely in the fall or winter of this year.

My out-of-consensus call for the next Fed move to be an easing – rather than a hike – is based on a simple point: the U.S. economy is headed towards a sharp recession by early 2007 . Thus, while most commentators are still pondering and stressing the alleged “tightening bias” in yesterday’s FOMC statement, it is because they are still deluding themselves that the economy will face a soft landing; unfortunately the landing will be hard and ugly with a severe recession. Thus, unless core inflation sharply rises (as it could if oil goes sharply higher from here), there is only one choice and direction for the Fed ahead: to cut the Fed Funds rate as soon as there are strong signals that the economy is spinning into a recession. Such recession signals would – with one caveat – certainly lead to a cut in the Fed Funds rate as – unless stagflationary effects of higher oil become much larger – the inflation rate will tend to fall in the coming recession as demand falls, the unemployment rate goes up and wage growth slows down once workers lose jobs.

The only caveat to this easing call is a nightmare scenario where you have true stagflation, rather than stagflation-lite: i.e. a scenario where oil price keep on rising and get into core inflation via second and third round effects while the economy is spinning into a sharp recession. I.e. you need the anti-inflationary forces of lower demand and higher unemployment to be weaker than the inflationary forces of geopolitical shocks bringing oil prices higher (as non-energy commodity prices will start to fall sharply as soon as the U.S. recession trend is evident) for inflation to significantly rise in the coming recession.

Could this true stagflation (inflation sharply up while growth goes to zero and then negative) occur? It is possible only if geopolitics (tensions with Iran, a worsening security situation in Iraq, a wider Middle East conflict, a worsening civil war in Nigeria, a greater confrontation with Chavez) or “nature” (a major Katrina-style hurricane, even worse pipeline problems in Alaska or somewhere else, another workers’ strike in the North Sea) lead to sharply higher oil prices. During recessions, usually prices for energy and non-energy commodities sharply fall (as both demand and supply are price inelastic); but while a US recession and global slowdown will sharply hit non-energy commodity prices, energy prices may remain close to current levels – rather than sharply fall – if geopolitics or “nature” causes another supply shock.

But barring such a major oil supply shock, as the economy spins into a recession, inflationary pressures will dampen over time (with a possible lag given the inflation pressures in the pipeline) and the Fed will get into a panic mode of having realized that it overreacted – with excessive tightening until now – and will thus cut rates. This is the same pattern that we observed in 2000-2001.

In conclusion: investors are still behind the curve debating whether the FOMC statement suggests a further hike sometime in the fall. The reality is different: the next move of the Fed will be easing, most likely in the fall when the signals of a recession become too self-evident for the Fed to ignore them. The only thing that could prevent a Fed Funds rate cut (and lead the Fed to keep a pause or even hike) or postpone the cut into 2007 is a sharp spike in core and actual inflation driven by a further oil shock or a build-up of domestic inflationary forces. But that would be a true nightmare scenario for the Fed and for the economy: a recession with a sharply rising inflation. Then, if the Fed lost control of the inflationary process, it may well be forced to hike even during an ongoing recession. But this scenario is, still, highly unlikely. The most likely scenarios is a slowdown and recession that cools down inflationary pressures (or, at least, does not stoke them further) and forces the Fed to cut the Fed Funds rate. But, as I have persistently argued, even such Fed ease will not prevent the coming recession. The recession boat has left the harbor and there is very little the Fed can do to prevent it. In 2000 the Fed failed to achieve a soft landing; this year we will get the same pattern as in 2000-2001 but a much harder landing than in the previous recession.

Mish Comments

I find the conclusion faultless and time will tell if we are correct.
Unfortunately I can not say the same for some of the reasoning.
Oil is a red herring. I will ask Roubini the same question I asked someone on Silicon Investor earlier today: If Saudi Arabia was taken over or their well production suddenly declined by50% causing oil futures to soar to $300, would the correct response for the US to be to hike interest rates to slow demand?

Would not that spike slow economic activity in and of itself (and rather quickly)? I hope the answer to that is obvious: Rising oil prices on account of peak oil or geopolitical factors have nothing to do with inflation.

Peak oil is a global phenomenon. If and when the market is ready, the market will find an answer to peak oil. I do not know what that solution is but I am sure it will come.

Given that global demand is rising, and arguably access to cheap oil is diminishing, how high would interest rates in the US have to get to affect global demand enough to bring prices back down? 8% 10% 18%? What would those interest rates do to everything else?

Interest rate hikes are a blunt instrument, even more so in a global economy. Attempting to control global prices of a commodity such as oil via US interest rate policy is a fool’s mission, yet every day I hear the same talk over and over (the Fed has to stop oil inflation or other such nonsense).

What is Inflation?

The basic problem is that people do not understand what inflation is.
I will keep harping on this theme from now until eternity.

Inflation: What the heck is it?

Inflation is an increase in money supply and credit.
Deflation is a decrease in money supply and credit.

Q. Where does oil fit into that picture?
A. It doesn’t.

If anything, rising oil prices would act as a drag on the economy shutting down discretionary spending in other places. This simply is not the 70’s where a wage/price spiral is likely to soar out of control. Global wage arbitrage puts a lid on that idea. Repeat after me: This is not 1970. Politicians are hoping for higher wages (even promising them) not attempting to WIN (Whip Inflation Now) by putting a lid on them.

Consumers are already Tapped Out. Dramatically rising oil prices topped off by a Fed attempting to control that price would likely bankrupt a lot of people. Increasing writeoffs of debt is a deflationary thing.

I do agree with Nouriel Roubini that rising prices are a lagging indicator. It is one of the reasons why the Fed always seems to be chasing its tail. The Fed no more knows the “natural interest rate” than I am likely to star in a movie with Madonna or beat Tiger Woods at golf. Yet, I agree with Roubini that the Fed has overshot. The Fed way overshot in the other direction too. The fact is that the Fed always overshoots because they are constantly looking in the rear view mirror (along with most everyone else).

Focusing on the price of anything, but especially the price of something with a very inelastic price curve like oil in the face of geopolitical factors, increasing global demand, and peak oil is simply a serious mistake. It is silly to even try. Yet try they do.

The Fed is the problem and the market is the solution.

The Fed does not know the correct price of corn, or soybeans, or salmon yet somehow everyone thinks they know what interest rates should be. If the Fed set the price of corn too low there would be underproduction causing eventual shortages. If the Fed set the price too high there would be mammoth overproduction. It is obvious (I hope) that the Fed does not have a clue what the price of corn or oil should be, especially in a global economy.

Even if by some miracle the Fed knew what the price of oil or corn or anything else should be (an impossibility), the odds of setting the correct US interest rate to maintain that price would still be impossible (interest rate decisions by other countries would affect the result).

Here is the absurdity of the situation:

  1. The Fed has no idea what the correct price of oil should be.
  2. The Fed does not know what the correct interest rate should be either.
  3. People (and the Fed itself) thinks the Fed can set interest rates to control the price of oil when the Fed can not possibly know what the price of oil should be in the first place.

The solution is obvious: Abolish the Fed and let the market worry about both oil prices and interest rates.

Yes, the next move in interest rates is indeed likely down.
The problem is that the market should be deciding when and by how much, not some bureaucrats who do not realize that the housing bubble that is now popping is largely their own fault. Heck, the sad state of affairs is that the bureaucrats at the Fed do not even know what inflation is in the first place.

Mike Shedlock / Mish/