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US: Fed's deflation fears are easing

Thu, Jun 25 2009, 06:59 GMT
by Signe Roed-Frederiksen

Danske Bank A/S

• The FOMC statement was less dovish than we had expected. The committee decided to retain the target range for the fed funds rate and leave the size, timing and scope of the Fed’s security purchase programmes unchanged.
• In general, the committee has become less worried about deflation and more optimistic on growth. Still, inflation pressures are regarded as absent with slack in the economy set to keep cost pressures in check despite the recent rise in commodity prices.
• The statement repeated that the fed funds rate will be kept at exceptionally low levels for an extended period and sent only a very vague hint on exit strategies. Treasury yields rose following the statement resulting in a slightly steeper curve.
• The Fed still has the opportunity to alter the Treasury purchase program at its August meeting. However, we believe the Fed will remain sidelined with the way now open for higher 10-year yields and further steepening of the yield curve over the coming months.

Details

The FOMC decided to leave the fed funds rate at the current target range of 0.00-0.25% and maintain existing targets for purchases of MBS, GSE and Treasuries. There was only a very vague hint concerning exit strategies in the statement’s very last paragraph stating that “adjustments” to credit and liquidity programs will take place as necessary.

The statement is generally less downbeat on growth saying that "the pace of economic contraction is slowing” and that “household spending has shown further signs of stabilisation”. Furthermore, the FOMC sees “businesses making progress in bringing inventories in alignment with sales” and notes that financial conditions have generally improved.

Deflation fears have clearly eased with the statement no longer referring to risks that inflation could fall below rates which best encourage economic growth and price stability. On the contrary, rising commodity prices are noted. Still, the committee expects inflationary pressures to remain subdued with slack in the economy expected to keep cost pressures in check.

With markets already discounting rate hikes in Q1 2010 we had expected the FOMC to make an effort to talk down rate expectations. Although the statement reiterated that “the fed funds rate will be kept at exceptionally low levels for an extended period” this was not enough to alter market expectations.

Assessment and outlook

The recession has led to a huge output gap in the economy. The unemployment rate has spiked to a level well above the NAIRU. Applying standard Taylor rules suggests the Fed should keep interest rates on hold at least throughout 2010. While we believe that the central bank will move away from the zero bound before then, we expect rate hikes to be off the agenda until the economy has credibly returned to trend growth and unemployment has peaked. We expect the first rate hike in Q3 2010.

The statement left the door open for changes to asset purchase programs. A scaling up in Treasury purchases can still be effected at the August meeting. However, we expect improved economic indicators, especially in the labour market, to keep the Fed sidelined. As a result, we believe 10-year Treasury yields will increase going forward in line with better economic metrics and more positive financial conditions. While this is likely to result in a steepening of the yield curve over the coming months, as we move closer to 2010 and to the start of rate hikes we expect the curve to flatten.

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Published on  Thu, Jun 25 2009, 07:01 GMT