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FOMC: A walkover meeting

Thu, May 10 2007, 08:00 GMT
by Peter Possing Andersen

Danske Bank A/S

Overview: Yesterday evening the FOMC decided to keep the fed funds rate unchanged at 5.25% and with practically no changes to the statement text the meeting was a walkover - at least in terms of surprises. The economic outlook as well as the forward-looking language was unchanged. Hence, the “soft tightening bias” remains in place and the basic message from the FOMC is essentially the same; monetary policy is on hold for a considerable period of time, but with a vigilant eye on inflation, which remains the predominant concern of the committee.

Details: There were unusually few changes to the wording of the statement. Only the growth section saw some cautious change with the committee’s ascertainment of slowing growth in the beginning of the year - merely a historical fact by now. While the description of the housing sector remained dull (ongoing adjustment), the baseline view of moderate (i.e. close to or slightly below trend) growth in the coming quarters was unchanged. This suggests that the positive readings from the ISM indices and the tender improvement in the orders data, have been countering some of the negative news in terms of slowing growth, a somewhat softer labour market and continued sluggish home sales data.

Both the inflation assessment and the forward looking part of the statement were unchanged in the contents. Importantly, the inflation remains the committee’s predominant concern and core inflation is still characterised as “somewhat elevated”. The combo of inflation as the predominant concern and the equivocal wording about “future policy adjustments” implies that the “soft tightening bias” remains in place.

Assessment & outlook: Bottom line is that FOMC’s baseline scenario remains unchanged. The committee still views moderate growth and gradually ebbing inflation as the most likely medium-to-long term outcome. This suggests that FOMC’s current wait-and-see attitude is likely to remain unchallenged for yet some time.

With no essential changes to the statement our view on US monetary policy remains unchanged. The combination of continued risks surrounding the growth picture (in particular the housing sector) and core inflation remaining “too high”, will keep the Fed on hold for a considerable period of time. This is in line with our 12-month forecast of 5.25%. In the longer term, we continue to view a Fed hike as more likely than a cut, assuming that our forecast for the economy to return to trend growth during H2 and into 2008 plays out.

Current statement as of May 9:

“The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.

Economic growth slowed in the first part of this year and the adjustment in the housing sector is ongoing. Nevertheless, the economy seems likely to expand at a moderate pace over coming quarters.

Core inflation remains somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.

In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”

Previous statement as of March 21:

“The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.

Recent indicators have been mixed and the adjustment in the housing sector is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters.

Recent readings on core inflation have been somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.

In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”

Financial implications:

• FX markets: Praying for a patch of blue sky. The Fed's humble hope is that growth re-accelerates and inflation moderates. If and when that happens, the outlook for the US dollar will change markedly for the better. For now, however, this outcome remains but one of several possible trajectories. The Fed made few changes to its March statement, but the ones made were not insignificant. Economic indicators are no longer seen as mixed, instead the central bank states the plain fact that growth has slowed and that the housing correction remains "ongoing". It expects growth to expand at a moderate pace, but this is neither a new forecast nor one that it can (yet) back with hard data. It remains concerned that inflationary pressures will fail to moderate and sees this as the predominant concern. The bottom line is that the Fed won't come to an immediate rescue should growth fail to recover. It also suggests that rate hikes will come hard at the heels of any recovery. To us, this suggests two things. First, stagflation remains a risk for the dollar in the coming months. Second, the quality of the economic performance elsewhere is superior to that in the US, particularly in the euro area. As we continue to expect the ECB to surprise markets by delivering more rate hikes than currently priced, there is little in the Fed's decision last night to suggest the EUR/USD is headed lower and we continue to see risks biased to the upside in the coming months.
  Teis Knuthsen, tekn@danskebank.dk, +45 45 12 84 95.
• Equity markets: The equity market closed at a higher note following yesterday’s FOMC statement. This reaction indicates that Wall Street is quite comfortable with the current “stable policy” line. This is also in line with our view as we foresee higher market uncertainty in a response to a scenario in which Fed is raising as well as lowering the fed fund target rate. The current Fed position keeps Fed out of the equation of pricing the US equity market, and for now this is the best position for the market.
  Morten Kongshaug, mokon@danskebank.com, +45 45 12 80 57

Published on  Thu, May 10 2007, 08:02 GMT

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