FOMC: Preview of Policy Meeting
Overview
On Wednesday night at 20:15 CET the Federal Open Market Committee (FOMC) will announce its policy rate decision. In line with the general expectations in the market and among analysts, we expect the FOMC to keep the fed funds rate unchanged at 5.25%. Focus will therefore centre on the wording of the statement. Generally, we expect little rebuilding in the statement, with the FOMC retaining its "soft tightening bias".
Activity
With activity indicators posing positive as well as negative surprises in the inter-meeting period the overall growth picture remains largely unchanged compared to the last meeting. However, on balance one can argue that the forward-looking picture has improved, as some of the concerns on corporate spending and the US manufacturing sector have, with the recent data flow, been easing. This view stands in opposition to the continued disappointing home sales data and the fact that high US gasoline prices are set to dampen consumer spending significantly in Q2. We forecast GDP growth to recover to 2.0-2.5% in Q2 and to improve further heading into H2. The baseline Fed view of moderate expansion (ie, just below or close to trend) during the coming quarters is likely to remain intact. While the recent improvement in the ISM indicators could provide room for some cautious optimism in the statement, the assessment of the housing market will most likely remain dull.
Inflation
Underlying determinants of wage and price inflation suggest that high inflationary pressures remain in place. However the readings on core inflation, unit labour costs and wages have recently been slightly more comfortable from a FOMC perspective. Even so, there is still limited evidence that inflationary pressures are easing for real. We expect core inflation to move sideways during 2007 close to the current levels. That said, annual core inflation could be flirting with the upper end of the comfort zone in the coming months. The slightly more comfortable inflation picture facing the FOMC embeds the risk for a minor softening in the inflation assessment. On the other hand, the fundamentals leave very little room for a general easing in the inflation rhetoric. Hence, inflation will remain the primary concern of the FOMC.
Fed guidance
The recent key figures suggest that the balance of risk has become a little more comfortable for the FOMC during the inter-meeting period: forward-looking growth indicators on balance have become more promising and inflation indicators have been easing slightly. Given this, the FOMC is likely to remain relatively comfortable with the current policy stance. From this perspective, the forward looking part of the language will most likely remain unchanged, with the current "soft tightening bias" remaining in place.
Outlook
The combination of continued risks surrounding the growth picture and core inflation remaining "too high", will keep the Fed on hold for a considerable period of time, which is in line with our 12-month forecast of 5.25%. In the longer term, we continue to view a Fed hike as more likely than a cut, assuming that our forecast for the economy to return to trend growth during H2 and into 2008 plays out.
Financial implications
Equity markets: Quite frankly, if we knew the direction of the Fed's next rate move, we would still be unsure of the equity market response. It all depends on the mix of data at hand when FOMC decides on the move. In our view, the data is still too unclear for Fed to move rates at all. Still, the equity market sees a rate cut as the most likely next move from Fed, initiated to stabilise the current slow down for the US economy. In our view, it would most likely be a negative environment for equities if Fed was forced to cut interest rates due to economic weakness. The strong equity market performance since Fed went ‘on hold' in August 2006 suggests that Fed's current stance is the most comfortable scenario for equities. As we believe that Fed will continue its current policy, the equity market will most likely focus on other factors such as M&A and earnings.
Morten Kongshoug, Equity Strategist, +45 45 12 80 57, \n [email protected] This email address is being protected from spam bots, you need Javascript enabled to view it
FOMC key statements
Meeting statement of the March 20-21 meeting:
"The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.
Recent indicators have been mixed and the adjustment in the housing sector is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters.
Recent readings on core inflation have been somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.
In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.
Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."
Key statements from the Minutes of the March 20-21 meeting (released April 11):
"In their discussion of the economic situation and outlook, meeting participants agreed that, while recent economic data had been mixed, the economy was likely to expand at a moderate pace in coming quarters. Although the housing sector adjustment continued, accumulating data suggested that the demand for homes was leveling out ... However, additional evidence of sluggish business investment and recent developments in the subprime mortgage market suggested that the downside risks relative to the expectation of moderate growth had increased in the weeks since the January FOMC meeting."
"At the same time, the prevailing level of inflation remained uncomfortably high, and the latest information cast some doubt on whether core inflation was on the expected downward path. Most participants continued to expect that core inflation would slow gradually, but the recent readings on inflation and productivity growth, along with higher energy prices, had increased the odds that inflation would fail to moderate as expected; that risk remained the Committee's predominant concern. "
"Nonetheless, the combination of generally weaker-than-expected economic indicators and uncomfortably high readings on inflation suggested increased downside risks to economic growth and greater uncertainty that the expected gradual decline in core inflation would materialize."
"The Committee agreed that further policy firming might prove necessary to foster lower inflation, but in light of the increased uncertainty about the outlook for both growth and inflation, the Committee also agreed that the statement should no longer cite only the possibility of further firming. Instead, the statement should indicate that future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."
Key statements from Bernanke's testimony to the JEC (March 28):
"At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency. We will continue to monitor this situation closely."
"Overall, the economy appears likely to continue to expand at a moderate pace over coming quarters. As the inventory of unsold new homes is worked off, the drag from residential investment should wane. Consumer spending appears solid, and business investment seems likely to post moderate gains. "
"Although core inflation seems likely to moderate gradually over time, the risks to this forecast are to the upside. In particular, upward pressure on inflation could materialize if final demand were to exceed the underlying productive capacity of the economy for a sustained period."
"To date, the incoming data have supported the view that the current stance of policy is likely to foster sustainable economic growth and a gradual ebbing in core inflation."
Selected statements from FOMC members since March 21:
Mishkin (voter, neutral) - March 23: "Looking to the medium term, I am less optimistic about the prospects for core PCE inflation to move much below 2 percent in the absence of a determined effort by monetary policy."
Geithner (voter, neutral) - March 23: "These concerns have been heightened in some quarters by the problems currently being experienced in the subprime mortgage sector. It will take some time before the full implications are understood and the full impact can be assessed. As of now, though, there are few signs that the disruptions in this one sector of the credit markets will have a lasting impact on credit markets as a whole."
Moskow (voter, hawk) - March 28: "...my assessment is that the risk of inflation remaining too high is greater than the risk of growth falling too low. Of course, whether policy will need to be adjusted and the degree of any adjustment will depend on the data we see in the months to come and how that data influences our forecast of the economy."
Poole (voter, hawk) - April 3: "Inflation is a major concern and if inflation were to head up in a convincing way from the current level, I could be in favor of a rate increase at some point"
Moskow (voter, hawk) - April 11: "So far this year inflation has been somewhat elevated, highlighting the risk that inflation could stay stubbornly high." ""For the balance of 2007, economic growth likely will average modestly below potential. But I expect that growth will be picking up gradually over the coming quarters and return to near potential by 2008."
Mishkin (voter, neutral) - April 20: "I continue to believe that the current stance of monetary policy is likely to foster sustainable economic expansion and a gradual ebbing in core inflation"
Yellen (non-voter, dove) - Aril 26: "The current stance of policy is likely to foster sustainable growth with a gradual ebbing of inflation over time. However, the inflation risks are skewed to the upside". "I still expect to see a moderate pace (of activity) in the second half of the year. At the same time, much of the news pertaining to the first quarter has been disappointing, and has raised the downside risk for growth"
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