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Fortuna audaces iuvat

Wed, Aug 6 2008, 16:46 GMT
by Yapi Kredi Bank Economic Research Department

UniCredit Group

The Fed left rates on hold but with a rather hawkish undertone, stressing that “Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee” and noting high inflation and elevated inflation expectations. Fisher dissented in favour of a rate hike. The statement is slightly less sanguine on growth—dropping the claim that downside risks to growth have diminished, already abandoned in Bernanke’s latest Testimony—but somewhat more hawkish on inflation. The FOMC did not even mention the recent correction in commodity prices (too soon to tell) except by underscoring that “earlier increases” in commodity prices have fed through into higher inflation and inflation expectations, and stressing that the inflation outlook remains highly uncertain. The tone of the statement is perfectly balanced, and confirms my view that the Fed is looking for the right time to start normalizing rates. Fortuna audaces iuvat. I believe the Fed is on the right track, making a courageous bet on the resilience of the economy and on the power of the joint monetary and fiscal policy jolt already delivered. The markets have listened, and the short-end rates already incorporate the FOMC’s hawkish temptations. All of this in turn is helping to stabilise FX markets, which is crucial to also help a gradual stabilisation of sentiment in financial markets at large. So the Fed might be partly making its own luck, and if fate really helps the brave, we might see an important step towards normalization at the turn of the year—barring a renewed sudden deterioration of the growth or financial outlook, of course. Our call remains for Fed funds at 3.0% by mid-2009.

One year since the onset of the financial crisis, the Fed is still steering policy against an extremely dense fog of uncertainty. While the crisis has moved from an acute to a chronic stage, it is still too early to be sure that the worst is behind us. Indeed, recent data and events have given a very clear picture of what could still go terribly wrong: The housing market still shows no signs of nearing bottom; the deterioration in the labor market continues apace, with the unemployment rate now at a 4-year high of 5.7%, a 0.7pp rise in three months; the stress on US consumers is becoming increasingly obvious, and their surprising resilience is beginning to show some cracks, notwithstanding the tax rebates. Meanwhile, the well known troubles of Fannie and Freddie have underscored the fragility of both the housing and financial sector. Main street is not faring much better, and our credit strategists noted today that the CDS market prices a near certainty that at least one of the US big three automakers will go into bankruptcy. There is therefore a clear risk that the situation might take a sudden turn for the worst.

The Fed is well aware of the downside risks, but maintains a neutral bias, and I believe it is looking for the first opportunity to start normalizing rates. There are several reasons for this.

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Published on  Wed, Aug 6 2008, 16:49 GMT