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FOMC August 7th Meeting

Thu, Aug 2 2007, 07:20 GMT
by Rae Anne Dodds

BBVA Bancomer

• No significant changes to next week’s statement
• Hawkish sentiment will continue
• Fed funds rate will remain at 5.25%

Economic trends on track to meet the recently adjusted FOMC outlook

We do not expect any significant changes to the statement as economic performance matches Fed’s expectations. Data suggest that FOMC growth outlook of “a little below” potential for 2H07 and then rising in 2008 to a pace “broadly in line with potential output growth,” is likely to occur. Thus, the below average 2H07 growth rate (2.0% q/q saar) will not stimulate dovish bias. Particularly since the rebound in 2Q07 growth was supported by the nonresidential investment (NRI), as opposed to the expected “substantial swing in inventory investment.” Moreover, the Fed’s explanations for the expected GDP growth acceleration –waning of the residential investment drag and improvement in NRI– are coming to fruition. The housing sector remains a drag to the economy, but the 2Q07 negative contribution to GDP growth (0.49 pp) was nearly half of the 1Q07 level (0.93 pp) and below the 2006 average (0.80). NRI was stronger than expected in 2Q07. July’s Beige book reported that capital spending has increased and commercial and industrial lending expanded, thus suggesting maintained firmness in business investment. In addition, solid job creation is expected to support moderate personal consumption growth.

Despite that core inflation continues declining, headline remains elevated and member communications have reiterated the FOMC hawkish sentiment. Moskow stated that “the risk of inflation remaining too high is greater than the risk of growth falling too low,” while Yellen views an “asymmetric policy tilt” as “appropriate given the upside risks to inflation.” In addition, the recent downward revisions to 2004-2006 GDP lowered potential output and NAIRU. This implies a narrowing of the output gap and that the downside risk of GDP growth falling below Fed’s range has diminished.

Fed funds target will remain at 5.25%

Assuming that GDP growth remains close to potential and core inflation continues to moderate, the FOMC will remain on the sidelines with a hawkish bias. In fact, lower long-run output, reduced measured productivity and a narrower output gap will increase the concern of potential inflationary pressures. The Fed is unlikely to make a reference to recent financial market volatility as it has not altered the Fed’s outlook nor is it creating a systemic risk. Historical precedence suggests that only extreme circumstances that endangered the financial payment system merited a monetary policy reaction.

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Published on  Thu, Aug 2 2007, 07:23 GMT