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FOMC: Moving towards neutral

Thu, Mar 22 2007, 14:46 GMT
by Peter Possing Andersen

Danske Bank A/S

Overview:

At yesterday’s policy meeting, the Federal Open Market Committee, the FOMC, kept the fed funds rate unchanged at 5.25%. Generally, the statement saw quite some rebuilding, and the removal of the “addi-tional firming” language was the most significant change indicating a move towards neutral.

Details:

Generally, the risk assessment was more divided in yesterday’s statement compared to the Janu-ary meeting, with softer language on growth and tougher language on inflation.

More specifically, the growth section acknowledged that growth indicators had recently been more mixed. Importantly, the committee also softened its stance on the housing market, changing its language from “tentative signs of stabilisation” to “ongoing adjustment”. However, the committee did not alter its basic view that the economy will expand at, or just below, trend over the coming quarters. The committee did not make any specific reference to subprime jitters, but it might have affected their overall assessment of the housing market.

While the growth section was softer, the inflation assessment was toughened up. The statement noted that “recent readings on core inflation have been somewhat elevated” while the January statement said that “in-flation has been improving in recent months…”, hence acknowledging the more unfriendly inflation readings during recent months. The committee retained the view that inflation will moderate, but continued to men-tion high resource utilisation as the main risk to this view. Moreover the predominant concern of the com-mittee remains that inflation will fail to moderate.

Most surprising was the complete rephrasing of the forward-looking section of the statement. While the committee states directly that inflation remains its predominant concern, it no longer mentions “additional firming“, but talks about “future policy adjustments”, which could in reality go either way. This is clearly a move towards a neutral bias. With the inflation data worsening in the inter-meeting period, this is an im-plicit indication that the committee has become more concerned about the growth outlook. Indeed, the overall statement indicates that the balance of risk has turned less favourable for the FOMC in recent months, with more risk to both the growth and the inflation outlook.

Outlook:

Given yesterday’s statement we continue to see the FOMC on hold for most of 2007. While we still favour a resumption of the tightening cycle late this year, in line with our expectation of improving growth and “too high” core inflation, this has admittedly become more uncertain with the FOMC moving towards neutral.

Financial implications:

- FX markets: Changes to the Fed's statement yesterday is confirmation of prevailing market concerns regarding the outlook for the US economy. From a currency perspective, it underscores the present di-chotomy between the US economy and the performance of global growth ex US. To be sure, the USD is left with little cyclical support at the moment. Seen from the dollar, it is bad news that the outlook in the US has deteriorated sufficiently to warrant recognition by the central bank. However, it is also a good sign that the Fed is sufficiently alert to the situation to prevent fears of a stagflationary environment to get in the way of possible rate cuts, which was the case in the spring of 2006. Considering the amount of bad news already priced to the rate markets (a rate cut is fully priced by end-September), it is not ob-vious to us that EUR/USD can move substantially higher in the near term. At the same time, it is diffi-cult to become dollar bullish considering the lack of cyclical support. Technically, we expect EUR/USD to correct lower intra-day towards 1.3350 before rising towards a high of 1.3450 in the coming days. Pricing is looking somewhat stretched so we would be looking for a more significant correction towards the 1.32 area further out.

Teis Knuthsen, +45 33 44 09 45, tekn@danskebank.dk

- Fixed income markets: The Fed's move towards a neutral bias represents an important event in the sense that it is explicitly acknowledged that the tightening cycle may have come to an end. In other words, the Federal funds target rate may have reached a turning point. As a result, the yield curve steepened sharply and the market discounts close to a 50/50 chance of a cut in the Federal funds tar-get rate by the end of the summer. We expect further declines in yield levels and further yield curve steepening today.

Peter Lildholdt, +45 33 44 08 72, lild@danskebank.dk

Published on  Thu, Mar 22 2007, 14:50 GMT