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US: FedWatch

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Making Sense of Increased Hawkishness

Tue, Jun 24 2008, 08:27 GMT
by Marcial Nava, Alejandro Neut

BBVA Bancomer

• • Pressures to both growth and inflation persist
  

• • Lower marginal benefits of further rate cuts and higher inflation risk point to a prolonged pause

• • Fed will keep its options open
  

In its next meeting the FOMC will probably maintain rates at 2%. After pursuing aggressive rate cuts for the last 10 months, we expect this to be the first meeting where the FOMC keeps rates constant, thus suggesting a floor in the current interest rate cycle.

The expected pause should not be interpreted as the end of recessionary risks. Quite the contrary, uncertainty has intensified on both factors affecting the Fed’s “Taylor equation”. On the one hand, the real economy still faces downside risks, which emanate from distressed financial markets that have not yet resolved a whole set of liquidity and deleveraging problems. But with current nominal interest rates at 2.00%, the Fed knows that further cuts will have little direct impact on growth. Board members recognize that the crisis is far from over, but the tone in recent speeches has shifted from the need for the Fed to provide liquidity to the need for Congress to get more involved and provide fiscal support.

On the other hand, inflationary pressures --coming mainly from large increases in oil and food prices-- have intensified while headline inflation has accelerated both for PPI and CPI indices. Although core inflation has remained immune to these pressures, expectations have been affected. Even though the Michigan one-year-ahead inflation expectation index is not a very reliable indicator of future inflation, it significantly increased to 5.5%, a level not seen since 1982. Other indices have not shown such a dramatic rise, but they are showing an incipient reaction to current pressures. Chairman Bernanke stated that “… the latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations. The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.”, while Vice Chairman Kohn reemphasized that “Of greater concern is that some measures of longer-term inflation expectations appear to have edged up since last year... It is very important to ensure that policy actions anchor inflation expectations. This anchoring is critical.”

Thus, as long as balanced pressures persist for both inflation and growth, FOMC members will favor a prolonged pause under a waitand- see strategy that may well last until the end of the year. But if inflation expectations continue to deteriorate, the Fed will react.

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Published on  Tue, Jun 24 2008, 08:31 GMT