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FOMC: preview of policy meeting

Mon, Jun 22 2009, 11:10 GMT
by Signe Roed-Frederiksen

Danske Bank A/S

• On Wednesday, at 20:15 CET, the Federal Open Market Committee (FOMC) is set to announce its policy decision. In line with consensus we expect the FOMC to keep the Fed funds rate unchanged in the range of 0.00-0.25%.
• The meeting will be a balancing act. On the one hand, there are members of the FOMC who fear that inflation expectations will run rampant unless the Fed states that it is ready with exit strategies. On the other hand, other members worry about the market’s aggressive expectations for interest rate increases and the run up in Treasury and mortgage yields.
• We expect that the FOMC will sound more optimistic on economic outlook but at the same time stress that interest rates will be on hold for a prolonged period as inflationary pressure is expected to be absent for a long time to come.
• Regarding alternative measures, we expect the FOMC to hold the overall size of purchase programmes steady. However, it could choose to adopt a more flexible stance on the composition and the timing of the purchases. This would likely mean buying more Treasuries and less mortgage-related assets. It is difficult to predict the market reaction to such a complex statement but we prefer to be positioned for lower rates.

Activity: Economic indicators have in general shown further signs of improvement. Consumer spending has stabilised and housing market indicators suggests that residential construction could be close to a trough. Most importantly though is the recent improvement in labour market indicators. Job losses moderated significantly in May and jobless claims data suggests that the labour market has continued to improve in June. We expect the statement to acknowledge that the economic outlook has improved further.

Inflation: Commodity prices have moved up over the past six to eight weeks and surveyed inflation expectations have crept marginally higher. Monthly headline inflation has been volatile but core inflation continues to slow. The majority of FOMC members expects underlying inflation pressures to be absent for a long time to come due to the enormous amount of slack in the economy. However, other members fear that inflation expectations will get out of control if the Fed does not send a clear signal about its exit strategies. The statement will be a balancing act between the two camps. We expect the statement to reiterate that there is “risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term” but could add a comment on exit strategies, stressing that the Fed has the necessary tools to take back liquidity once the economy has fully recovered.

Bias and policy outlook: The recession has led to a huge output gap and the unemployment rate has spiked to a level well above the NAIRU. Even with a pick-up in growth, the output gap will be massive for a long time. Applying standard Taylor rules suggests that the Fed should keep interest rates on hold at least throughout 2010. We believe that the Fed could choose to move away from the zero bound before then, but rate hikes will be off the agenda until the economy has returned convincingly to trend growth and unemployment has peaked. Currently, markets have become too aggressive in their rate hike expectations and are pricing more than 75 basis points in hikes from the Fed over the next 12 months. We expect the FOMC to talk down the aggressive pricing of rate hikes and reiterate that rates will be held at exceptionally low levels for an extended period. The statement could stress that even though it expects growth to return to positive territory, the output gap will be huge and inflation pressures absent for a long time to come.

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Published on  Mon, Jun 22 2009, 11:13 GMT

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