• Contrary to market speculation, we do not expect any changes to policy measures or the balance sheet management at today's FOMC meeting.
  • The recent deterioration in data should warrant a softer tone in the statement. The growth section is likely to be downgraded, but with no material changes to the outlook.
  • The "extended period" language should be retained and the forward-looking section is likely to see a dovish twist indicating a softening in the policy stance.
  • While the statement will fundamentally support the current low level of yields, the market might be a bit disappointed when the Fed fail to announce further easing. Hence, the risk-reward is for higher yields going into the meeting.

Activity

Economic data has weakened over the past couple of months and is now highlighting the risk of a hard landing in H2. The combination of declining leading indicators, a significant setback in housing data, soft consumer spending growth and a moderate recovery in the labour market is likely to increase the concerns on the outlook at the committee. On a positive note, improving financial conditions and robust household incomes support the H2 outlook. The statement should acknowledge the recent

weakening in data and reflect a less upbeat growth picture with increased downside risks. We believe that the Fed will stick to its medium-term outlook for a moderate expansion.


Inflation

Core inflation has fallen below the Fed‟s comfort zone and remains on a downward trend, reinforced by the huge slack in the economy. 5y5y B/E inflation has declined recently but other measures of inflation expectations remain stable. The risk of a change in the inflation language is limited. The FOMC is likely to reiterate that inflation will remain subdued for some time, but could skip the note about declining commodity prices.


Bias and policy outlook

There have not been any big changes in communication from the central Fed members. However, among the local Fed presidents the hawks have softened along with the deterioration in data. Market speculation of further easing has intensified following reports in the news media that the Fed would be re-investing its proceeds from the MBS portfolio to avoid tightening the balance sheet. We believe that such an announcement would be premature but believe the Fed will indicate that the door is open should the outlook deteriorate further. The ‘extended period’ language is likely to be retained at this meeting and a dovish twist could be added to the forward-looking section. Furthermore, we believe it unlikely that Hoenig will repeat his dissent, therefore adding to the likelihood of a dovish shift in the bias.


Market pricing

The market has postponed the initial Fed hike to November 2011. We believe that the market could initially be disappointed should the Fed fail to announce further easing. However, the statement is not expected to change the fundamental outlook for low rates, which is currently in the Fed‟s interest.