Outcome: FOMC raises rates by ¼% and indicates the outlook for inflation pressures remains such that additional policy firming may still be needed. This is suggestive of the status quo and a Fed Funds rate peak of 5.5% and less-hawkish than consensus.
Statement content: In this case the language of the statement would very closely mirror the language of the May 10 statement and represent a continuation of the ‘data dependent’ outlook going forward. In essence, the Fed would be indicating that it does not yet have a firm grasp over the near-term inflation outlook and does not yet know when it will be able to step back from further tightening. The Fed may note that while price pressures remain elevated, they do not appear to be accelerating, while economic growth continues to moderate to a more sustainable pace, with particular note given to recent weakness in job growth.
Market Reaction: The dollar is likely to come under immediate selling pressure as this outcome would represent a disappointment for more hawkish views that slightly dominate the market going into the meeting. However, given the outlook for still higher rates in the future, the dollar’s downside should be limited to recent range lows of 1.2670/80 against the EUR/USD and 115.50/70 against the JPY in the immediate aftermath of the announcement and before Friday’s PCE report.
Scenario 2)
Outcome: FOMC raises rates by ¼% and signals that additional rate hikes are likely to be necessary to anchor inflation expectations. This is suggestive of more rate hikes and a Fed Funds peak of 5.75-6.00%, and is in line with relatively hawkish market expectations.
Statement content: The Fed is likely to observe that recent growth remains unexpectedly buoyant and inflation risks remain elevated in the near-term. The Fed is likely to single out persistently high energy prices and the risks these present to the inflation outlook. In this case, the Fed is continuing with its more recent hawkish rhetoric in which Bernanke cited “unwelcome” increases in inflation. The Fed will seek to demonstrate it’s commitment to stamping out inflation, even at the risk of undermining economic growth.
Market reaction: This outcome would mostly fit with the market’s consensus expectation and is likely to see the dollar move steadily higher, but in a choppy fashion, as traders conclude that additional rate increases are coming. Choppiness is predicated on the basis that the outcome is “as expected,” leading to some profit-taking from pre-positioned trades while fresh dollar longs are made based on the outlook for rising rates. The risk to the outlook for this reaction is that markets conclude future growth will suffer from higher rates, and that inflation-based rate hikes will not support the dollar going forward.
Scenario 3)
Outcome: FOMC raises rates by ¼% and indicates that monetary policy is now deemed appropriate to ensure both price stability and sustainable economic growth. FOMC would also indicate that it will react to changes in the economic and inflation outlooks and revise policy if necessary.
Statement content: The Fed could indicate that recent increases in inflation are viewed as temporary while long-term inflation expectations remain contained. The Fed could also highlight their belief that economic moderation is underway and that slower growth, along with prior policy tightening, is expected to restrain inflationary pressures in the future. The Fed may point to the unevenness of the recent growth data, while highlighting declines in employment growth and lower disposable income as indicators of slower growth ahead.
Market reaction: This is the most dovish of the potential outcomes and could see the dollar decline rapidly as higher interest rate expectations unravel. US and other global equity markets could rejoice at the pause in monetary tightening in the world’s largest economy, and capital flows could shortly turn more favorable for emerging markets, further undermining the dollar in the process. Recent dollar lows at 1.2670/80 in EUR/USD and 115.50/70 in USD/JPY would be breached in short order, and further dollar losses would follow as anticipated rate hikes in Japan and the Eurozone take center stage.
Scenario 4)
Outcome: FOMC raises rates by ½% (50 bp) and indicates that monetary policy is now deemed appropriate to ensure both price stability and sustainable economic growth. They would also signal continued vigilance and that further policy action could be taken if the inflation outlook deteriorated, but that this appears unnecessary in the current outlook.
Statement content: The Fed could point to the unexpected and unwelcome nature of elevated price pressures in recent months for the need to act decisively now to forestall future inflation. At the same time, the Fed could point to the ongoing moderation in economic growth as the basis for pausing in further policy firming.
Market reaction: This is the outlier in terms of market expectations and could likely see the dollar rally sharply in the immediate aftermath of the announcement. However, the dollar’s rally is unlikely to be sustained unless the Fed also indicates a strong likelihood of the need to tighten further based on incoming data. If they do come out with a one-and-done 50 bp hike, the dollar is likely to revert to a multi-week period of weakness as the end of the policy tightening cycle removes the primary support for the US dollar. However, the sharp increase in interest rate differentials in favor of the dollar is likely to make the transition to dollar weakness a slow and choppy process.
Conclusion
In summary, the reaction to the decision tomorrow is complicated by the relatively even-based diffusion of sentiment in the market. At the moment, sentiment appears to be biased toward a more hawkish outcome suggestive of Fed Fund rates moving beyond 5.50% in the current tightening cycle. But the bias is relatively minor and I would attach a 40/60 split among market participants between scenario 1 & 2 above. Finally, while the FOMC announcement on Thursday holds the most drama, Friday’s core PCE (personal consumption expenditures, the Fed’s preferred inflation gauge) for May will be a critical piece of the puzzle going forward. Forecasts are for a relatively moderate 0.2% MoM increase (prior 0.2% MoM) and a steady YoY core rate of 2.1%. Whatever picture the Fed draws on Thursday will be heavily colored by Friday’s inflation report.
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