Fed preview: Softer tone on inflation but bar for QE4 is high

At Wednesday’s meeting we expect the Fed to do the following.

• End asset purchases.

• Keep the ‘considerable time’ forward guidance.

• Keep the ‘significant underutilisation’ description of labour resources.

• Soften the inflation language due to recent lower inflation prints, the decline in the oil price, the strengthening of the USD and a fall in market inflation expectations.

There will be no press conference or new projections with this meeting. The statement will be published at 19:00 CET as US is still on summer time.

• With unemployment at 5.9% – not far from the Fed’s long-term estimate of 5.4% – it is increasingly a stretch to state that there is significant underutilisation. However, we do not think the Fed wants to rock the boat by changing this phrase and there is no cost of postponing this characterisation of the labour market given how subdued inflation is at the moment.

• A key point will be whether the Fed mentions specifically that asset purchases could be restarted if the outlook deteriorates. We see only a 30-40% probability of this, as we believe the Fed is seeing the balance between costs and benefits of asset purchases increasingly weighted towards the costs. The Fed needs to strike a balance between having a firm hand in order to show continued optimism while also being flexible should the outlook weaken. However, the Fed is already expressing this flexibility in the current statement.

• We believe the Fed will use the timing of the first hike as first line of defence if the outlook weakens. If so, this could be reflected in adjusted rate projections in December. We believe the Fed will revert to asset purchases only if the outlook deteriorates significantly.

• Due to the recent decline in inflation pressures and more weakness in the global economy, we push our forecast for the first Fed hike to June 2015 from April 2015. With inflation pressures low, the Fed can afford to be patient. We still see the unemployment rate at the Fed’s long-term rate of 5.4% by April but believe the Fed will be afraid to rock the boat in financial markets and has a bias towards hiking too late rather than too early. A June hike is about six months earlier than is priced in the market currently but, given our expectation of a moderation in data in coming months, it is likely the market can keep this pricing for a while.

• We believe the outcome of the FOMC is unlikely to fuel a significant market reaction. The market is already discounting low inflation for a prolonged period and the moneymarket curve is pretty flat for the first year – the first rate hike is priced in by end-2015. Forward rates have declined some 35-40bp at end-2015 over the past month, so the market is already prepared for a dovish shift in the statement.