FOMC: Still on hold with a tightening bias

Overview

The minutes of the October 24-25 meeting of the Fed’s FOMC, released yesterday evening (CET), sprang no major surprises. There seemed to be a very slight shift towards inflation concerns, though. The general message was that the FOMC is still in wait-and-see mode, but with a continued bias towards tightening if core inflation does not ease fast enough. The minutes brought no conclusion to the inflation targeting issue. The bearish response to the minutes from equity and bond markets reflected a slightly more hawkish tone than justified by current market pricing. The dollar impact was rather insignificant.

Details

Compared to the previous minutes, the balance between inflation and growth risks was roughly unchanged. There was slight evidence, though, that concerns about economic growth seemed to have eased a bit more than concerns about inflation.

Both the staff and participants acknowledged that economic growth had slowed over the past couple of quarters, but reiterated that it was expected to regain momentum into 2007, expanding at a little below potential. Interestingly, it was noted that many participants - although still concerned about the housing slow-down - had drawn some comfort from the latest housing data, which suggested that the risk of an even larger housing correction had diminished somewhat. Moreover, the committee expected that the negative impact from the housing market would gradually wane. The general impression was that the committee had become slightly less worried about the growth outlook.

Members clearly were still uncomfortable with the current elevated level of core inflation, but participants and the staff continued to believe that economic growth at slightly below trend, coupled with lower energy prices, would reduce underlying inflationary pressures during the coming quarters. However, the commit-tee continued to emphasise its uncertainty about this outlook, stating that “All members agreed that the risks to achieving the anticipated reduction in inflation remained of greatest concern”. Importantly, the committee also mentioned the tight labour market and high wage pressures as an upside risk to the slow-down in core inflation. The minutes moreover emphasised that the committee’s objective is not only to bring inflation back down, but also to achieve this objective relatively fast so as to avoid the high level of core inflation feeding through into higher inflation expectations.

Outlook

In spite of the slight shift towards inflation concerns, we believe that the Fed will remain on hold for the remainder of 2006 and into 2007, as the FOMC assesses the magnitude of the housing market slow-down and its overall impact on economic growth. However, we also see inflationary pressures building further, with core inflation nudging above 3% in Q4 and into 2007. Add to this a gradual pick-up in growth during Q4 this year and into the first half of 2007, and we expect the Fed will eventually be forced back into tightening mode again next year. Our 12-month target for the fed funds rate remains at 6.00%.

Financial implications

• FX markets: The FOMC minutes are both a blessing and a curse to the dollar. A blessing since the central bank expects growth to recover, thus giving little support to calls for rate cuts. But also a curse since the bank seems relatively content leaving rates on hold to a considerable period. We are thus presented with no fresh impetus on relative rates, leaving the stage for the activists in ECB and BOJ to set the tone for now. That said, USD continues to benefit from a positive carry that is unlikely to be neutralised. Further, with markets still pricing a rate cut in 2007 our call for rate hikes suggests that the relative growth outlook will begin to move in favour of USD in the beginning of 2007. For now, EUR/USD may continue to explore well known ranges, but we consider a break above 1.30 as relatively unlikely before a medium-term pull-back sets in.
  
  
• Equity market: The minute emphasises Fed concerns regarding future inflation in a manner, which in the collective mind of the market may bring forward bad memories of the inflation scare from the troubled months of May to July. Therefore, Fed’s minutes will definitely assure that Wall Street does not forget the current inflationary risks. Still, in the broad context Fed is safely on hold, which is a clear positive for S&P500 both relative to other global equity markets and in absolute terms. Remember, that Fed’s tightening policy 2004-06 forced the market valuation lower. With Fed on hold, P/E multiple expansion is again a possibility for the US equity market as already experienced since August.
  
  
• Fixed income markets: The continued focus on inflationary risks in the minutes did bring up the US 2yr treasury above the levels we saw before the large drop on Tuesday. The market's previous expectations of a 40% chance of a cut in March have now been reduced to 20% likelihood. This is in line with our view of 2yr yields drifting higher. The growth uncertainties are still considerable, and the data that have come out since the last FOMC meeting must be said to on balance have added to the downside risks to growth. We thus keep our view that we will see a continued flattening of the yield curve going forward.