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. Then, the Fed expected a soft landing and paused in June 2000 six months before the onset of the recession. But the tech bust led to a growth slump and then recession – like the housing bust will now lead to a recession – and, once the Fed realized too late at Christmas in 2000, that the recession was coming it started to cut the Fed Funds rate – in between FOMC meetings – as early January 2001. This Fed Fund aggressive easing in 2001 did not prevent the mounting recession; and the Fed easing this fall or winter will – similarly - not prevent the coming US recession.

Investors should not read too much into the still “tightening bias “of the Fed in yesterday’s FOMC statement. Effectively, the risks are now balanced – as the Fed sees it – with downside growth surprises being as likely or more as upward inflation surprises. And the Fed has already accepted that core inflation through 2007 will be above the 1-2% range. Again, it worth reading the Fed Minutes of 2000 when the economy went from 5% growth in Q2 to 0% growth by Q4 and outright recession in Q1 of 2001. Then, like now, the Fed was worried about mounting inflation pressures throughout 2000; and even after the June 2000 pause, the FOMC minutes of September and November 2000 show a Fed clueless about the risks of the sharp growth slowdown that was underway and still very worried (in September) and quite worried (in November) about inflation. Even then the Fed expected a soft landing and it got a hard landing.  So, the Fed may be doing the same forecasting mistake now underplaying the recession risks.

So, leading Fed watcher John Berry – citing my recession call and that of DeLong – says today that no one at the Fed is yet worried about a recession. But Fed officials are much more worried about the recession risk than they are claiming or admitting in public.  The simple proof: why would the Fed ever pause, as it did yesterday, when all inflationary  signals and pressures are mounting (headline, every  measure of core, wage growth, falling productivity growth, sharply rising unit labor cost, oil, commodities, you name it)?

Why? The only and simple answer is: they are starting to get scared of the coming recession. Their official argument or excuse for the pause is, of course, that the delayed effects of previous tightening that are in the pipeline and the slowing economy will lead to a slowdown in inflation. But investors should read more carefully the FOMC statement. I have been speaking for the last 8 months of the Three Ugly Bears of slumping housing, high oil prices and the delayed effects of rising interest rates triggering a recession. And yesterday the FOMC endorsed the Three Bears view by stating: “Economic growth has moderated from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.?”  Three Bears!  Is that plain English clear or what?

Then, the Fed also added: “inflation pressures seem likely to moderate over time, reflecting contained inflation expectations and the cumulative effects of monetary policy actions and other factors restraining aggregate demand.” So, lagged monetary policy will slow down the economy by pushing demand down and unemployment up thus leading to lower inflation; and, on top of the “other factors restraining aggregate demand” will slow down inflation. What are those factors? In Q2 a fall in residential housing, a fall in consumption of durables, a fall in real investment in software and equipment, an increase in inventories as demand slows relative to output. And, as the Fed says, these forces will be stronger ahead: in fact, if these anti-inflationary forces did not prevent a rise in inflation in Q2, the Fed must believe that the fall in durables consumption, in housing, in non-residential investment and in other components of aggregate demand will be larger in H2 than in H1 to trigger the fall in investment. The Fed is telling you that it expects demand to slow further – regardless of the effects of past monetary tightening – and thus lead to lower inflation. Since any basic macro model – say the well respected model of Larry Meyer’s Macroeconomic Advisers that is closely followed by the Fed - tells you that only a significant increase in the unemployment rate will stabilize and then reduce core and headline inflation, if the Fed truly believes that inflation will peak and stabilize or fall in H2 or by early 2007 it must also believe that the growth slowdown will be much more severe than it is admitting it in public. So, there are only two options: either the Fed does not believe that inflation will stabilize in which case it is pausing now because it is already panicky about the recession; or, if it truly believes its own forecast of slowing inflation, it must be expecting a sharp economic slowdown, a much sharper one than the Bernanke forecast or the Fed forecast of a soft landing. 

Indeed, Berry, after citing my views on the risks of a recession said: “Well, Fed officials recognize there are substantial risks ahead, particularly given the pressure of high energy prices on both inflation and consumer spending. None of them is expressing concern that a recession is likely.” So, while Fed officials may not believe that a recession is likely, they are not excluding  - now in public via the mouthpiece of the only Fed watcher who is a true FOMC insider – that there are “substantial risks” to the growth outlook. Is that clear? Substantial risks…Also, as Berry put it: “Nevertheless, Fed officials are generally sticking by their collective forecasts of slower, but still solid, growth in the second half of the year, though they have to be somewhat troubled by the unexpected dip in business investment in new equipment and software in the second quarter.” So, again, Fed officials are troubled that non-residential investment that was supposed to pick up and sustain aggregate demand at the time when housing is falling and consumption growth is slowing, is instead headed south. This fall in non-residential investment is not a surprise, as I have argued before: corporations are flush with cash and profits but they do not see any good real investment opportunities as there is excess capacity and as demand is now slumping. Thus, the unprecedented share buyback bonanza – the biggest in US history - which we are now experiencing proves that firms do not have any good productive investment use for all the profits they have; and they are thus returning these profits to shareholders. Of all bearish signals in the economy, this investment slump and buyback bonanza is one of the strongest leading indicators of the coming recession.

It is true that the Fed has kept a formal tightening bias by suggesting that additional firming of the Fed Funds rate cannot be ruled out given current inflationary pressure; but it clearly stated that “extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.” So, the Fed is fully data dependent. And this means that if the economy slows down more than expected, there will be no firming and a pause that becomes a stop may end up being a cut. The risks are clearly balanced now in the Fed view: there are downward risks to growth and upward risks to inflation that, in the Fed view, will be moderated by the economic slowdown.

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.

Tomorrow Thursday the Financial Times is publishing an op-ed of mine where I summarize my recession call. Readers with a subscription to the FT can already read it online here.