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Fed keeps its cards close to its chest

Thu, May 10 2007, 07:49 GMT
by KBC Market Research Desk

KBC Bank

• Fed keeps Fed Funds target unchanged at 5.25%
• …and barely changes statement...
• …as it wants to have more evidence on slowing inflation …
• The door for rate cuts in 2007 remains open, but window narrows…
• Equities gain, the yield curve bear flattens and the dollar does nothing

Fed keeps rates unchanged….

For the seventh consecutive meeting, the Fed kept its Fed Funds target rate unchanged at 5.25%. Just like in previous 2007 meetings the decision was unanimously. The statement was changed only marginally and the changes didn’t signal a change in the Fed views.

….while still stressing inflation risks….

The FOMC kept saying that “the predominant policy concern remains the risk that inflation will fail to moderate as expected” and added, like in April, that “future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. This paragraph of the FOMC statement was unchanged from the March one.

The paragraph on inflation was barely changed. The Fed said that: “core inflation remains somewhat elevated” whereas in April it read: “Recent readings on core inflation have been somewhat elevated”. Not a big deal of a change: The drop of the words “recent readings” was only the recognition that the last month of inflation data was better. It is clear that the Fed wants to see more months of slower inflation before being convinced that inflation is tamed.

The Fed still expects inflation to slow over time, but isn’t convinced yet. Therefore, the next sentence of the statement was unchanged: “Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures”.

…Fed recognises slower growth, but says nothing about downside risks to the outlook….

The Fed recognized that economic growth slowed in the first part of the year and kept its assessment on adjustment in the housing sector unchanged: “Economic growth slowed in the first part of this year and the adjustment in the housing sector is ongoing”. Following a 1.3% growth in Q1, one couldn’t have expected the Fed to say less. It is a bit disappointing that the Fed didn’t recognize downside risks going forward. Indeed, the FOMC kept its longer-term assessment unchanged: “Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters.”

Our assessment

The Fed didn’t want to make a further step towards a softening in policy after it dropped during its March meeting its explicit tightening bias, a mice step towards some softening in stance.

The Fed remains worried on inflation and doesn’t want to react to one month of softer inflation data. The Fed probably doesn’t want to show its cards too early. It clearly speculates that the slower economic growth will, with the usual lag, affect inflation, but as a good poker player doesn’t want to show its cards too early. This would indeed inject a dose of optimism in the markets, drive market rates lower and in this sense obstructs the Fed’s objective of pushing inflation lower via sub-trend growth.

As we think that the housing crisis will drag on for longer, labour market conditions are now softening and together will impact household consumption, we expect again a very low growth figure for Q2. Other sectors like business investment or net export won’t be a sufficient offset. This will lead to a cooling of core inflation and give the Fed the opportunity to lower its rates. A step to a completely neutral stance should be taken during the June FOMC meeting, setting the stage for a rate cut during the August meeting. The July semi-annual testimony before Congress may lay the groundwork for a change in policy, exactly one year after the Fed stopped its tightening cycle. In this context, yesterday’s FOMC decision shouldn’t be considered as disappointing or closing the window to an easier policy. Of course, it is clear that for our time schedule on Fed decisions to come true, activity and inflation data should show a slowing from now onwards.

Market reaction

Equities spiked moderately lower on the release of the decision, but rapidly recouped losses and closed with moderate gains, the Dow at a new historical high, the S&P at the cycle high.

The Treasury market reacted negatively and the curve flattened a tad. The losses were rather moderate though and no important technical levels have been broken. So 2- year yields rose by 6 basis points (to 4.734%), the 10-year yield added 3.4 basis points (to 4.672%). This drove the 2- to-10-year yield spread down to –6.4 basis points, the lowest since March 12. Fed rate cut expectations were trimmed somewhat. The market now virtually excludes a rate cut in both June and August and discounts about a 20% chance on a rate cut at the September FOMC meeting. At the end of the year, the FF are expected to stand at about 5.05%, or a 80% chance on one rate cut.

The movements on the currency markets were marginal and no technical key levels were broken. EUR/USD fell about 30 ticks to 1.3535, while USD/JPY rose after the decision slightly, but only to end the session unchanged.

• Download full Fed keeps its cards close to its chest

Published on  Thu, May 10 2007, 07:53 GMT

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