FOMC: Neutral, With Rising Inflation Concerns

Daily Forex Fundamentals | Written by Danske Bank | Jun 26 08 06:35 GMT |


Overview: At the monetary policy meeting on Wednesday, 25 June, the Federal Open Market Committee (FOMC) decided to leave the fed funds rate unchanged at 2.00%. The decision was not unanimous, as Dallas Fed President Fisher voted for a rate hike.

The committee adopted a relatively neutral stance; the accompanying statement suggested more concerns about inflation and slightly fewer concerns about growth. We think it fair to say that the language leaned slightly toward the risk of inflation. However, the committee was not explicit about the balance of risks and nothing in the statement suggested that a rate hike is imminent.

Market reaction: Ahead of the meeting, the market was pretty hard priced for an early rate hike in the autumn. After the meeting the market reduced the odds of a September hike. Consequently, two-year Treasury yields initially dropped around 12bp, producing a steeper curve with a modest decline in 10-year yields of 5bp. EUR/USD jumped to 1.567 compared with 1.558 before the meeting. Initially, equity markets celebrated the improved prospects of a Fed on hold, but took back some of the gains later on.

Details: The details of the statement revealed a slightly more optimistic tone on growth, as the committee rephrased from 'the economy remains weak' to 'the economy continues to expand'. This reflects the betterthan- expected state of consumer spending, which has recently been buoyed up by the rebates. That said, the outlook seems little changed. The committee still described the financial market 'under considerable stress' and acknowledged further 'softening in the labour market.' 'Tight credit conditions, the ongoing housing contraction, and the rise in energy prices' will continue to weigh on economic growth.

As expected, the inflation language was scaled up. Although the committee still 'expects inflation to moderate later this year and next year' the continued increase in commodity prices and the elevated inflation expectations remain problematic. One interesting observation is that the committee left out any wording on core inflation, which has remained well-behaved in recent months. This potentially indicates a change in focus toward headline inflation and inflation expectations, which will bear watching in the coming months. We may be wiser in this respect after the Monetary Policy report to Congress (Humphrey Hawkins) in mid-July.

Again this month, the committee refrained from stating an explicit balance of risk. That said, a relative shift toward more inflation concerns and less concerns about growth was evident. Importantly, the inflation expectations were also mentioned in the forward-looking paragraph. Generally, we read the statement as being relatively neutral - but with a slight lean towards inflation concerns. In any case, this paragraph includes no obvious hints of an imminent rate hike.

Assessment & Outlook: The current statement will make it difficult for the Fed to hike interest rates already in August, unless a dramatic change occurs at the Monetary Policy report to the Congress in mid- July. The language needs some additional up-scaling before the FOMC is positioned to begin removing accommodation. In our view, this leaves the September meeting as the earliest point for a rate hike.

Generally the statement was close to our expectations (see Flash Comment - FOMC: Preview of policy meeting ). We do not alter our view that the FOMC will stay put for a long time. In our opinion the growth outlook is too troublesome to allow the FOMC to hike interest rates any time soon, as several negative factors (high energy and food inflation, credit tightening, contracting housing market) will remain in the equation in the coming quarters. Hence, we do not expect a normalisation of monetary policy to begin before well into 2009. That said, it will be important to keep a close eye on long-term inflation expectations. If persistent signs of erosion materialise, it could potentially lead the Fed to deviate from its usual behaviour and force the central bank to tighten policy much earlier than it normally does.

Current statement - June 24-25, 2008

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Recent information indicates that overall economic activity continues to expand, partly reflecting some firming in household spending. However, labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and the rise in energy prices are likely to weigh on economic growth over the next few quarters.

The Committee expects inflation to moderate later this year and next year. However, in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time. Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Voting against was Richard W. Fisher, who preferred an increase in the target for the federal funds rate at this meeting.

Previous statement - April 29-30, 2008

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 2 percent.

Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Gary H. Stern; and Kevin M. Warsh. Voting against were Richard W. Fisher and Charles I. Plosser, who preferred no change in the target for the federal funds rate at this meeting.

Danske Bank