Dovish FOMC Statement Contains Few Surprises

• ...Fed sees stabilization in labour market....
• ...and announces the completion of its asset purchases,...
• ...while it confirms its intention to keep rates very low for extended period of time...
• ... Governor Hoenig dissents again and wants the forward-looking guidance to be dropped
• No other governor joins Hoenig meaning a compromise might have been struck

Summary

The FOMC concluded its meeting with the release of a statement that showed no real surprises. The FOMC was somewhat more positive on the economic outlook, in line with the published data and kept its inflation outlook, subdued for some time, unchanged. Importantly, the FOMC continues to anticipate that economic conditions,....., are likely to warrant exceptionally low levels of the federal funds rate for an extended period. We thought they would have tweaked their forward looking language to make it less strict and allow them more flexibility going forward. Keeping the phrase intact means that currently the FOMC is moving slower-than-we expected towards a first tightening of policy, which nevertheless is still likely before year end. Finally, Kansas Fed governor Hoenig dissented again, as he thought the extended period of time of exceptional low levels was no longer warrented. This time he explained in more detail why. No other governor joined him though, which may mean that a compromise was struck between hawks and doves to remove the extended period language at a later meeting, probably the April 27-28 one, maybe on the condition payrolls growth had turned definitely positive. Markets reacted positively on the prospect of having for longer very low rates: equities gained moderately, but importantly pushed the S&P above cycle highs. Bonds gained too, if moderately, with the belly outperforming the wings marginally. The dollar lost some ground. Isn't that the best of all worlds?

Incremental upgrade of eco outlook

The FOMC repeated that economic activity continued to strengthen, similar to the January statement. The description of the economic situation was changed in three respects that support the view the Fed is becoming more confident in the outlook. Importantly, the labour market is now seen as stabilizing, while in January, the deterioration was seen abating. Secondly, business spending on equipment and software has risen significantly, while in January investment was described as “has picked up”. Lastly, “housing starts have been flat at depressed levels”, whereas housing was not mentioned in the January statement. We would read the last sentence as the glass is half full, notably stabilizing housing activity, but one might also see the reapparition of housing in the statement, as a negative development, or the glass is half empty.

Overall though, the firmer language on the eco is broadly in line with the eco data releases.

No changes in the inflation assessment

The assessment of inflation wasn't changed, despite the surprise drop in core CPI in January. Inflation is likely to be subdued for some time. The FOMC probably has a balanced view and sees neither inflation nor deflation risks.

Rates very low for extended period

While the FOMC statement contained some hints that the economic environment is slowly changing for the better and thus monetarey policy may be adapted at some point in the future, the FOMC clearly signalled that such a change in policy is not around the corner. So it kept its famous forward looking guidance saying that “economic conditions,..., are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” Whereas at the January meeting there was little specualtion on a change in this phrase, the opinions in markets were more divided this time and more in particularly, we thought there was a reasonable chance of a change. Why? In January governor Hoenig dissented on this point and wanted a more neutral and flexible “for some time” instead of “extended period of time”. In the run-up to yesterday's meeting, St-Louis Fed Bullard showed sympathy for Hoenig's position, while also regional governors Plosser and Evans showed some inclination to support Hoenig, or at least wanted to have a debate on the subject. We think there was indeed a lively debate on the forward-looking language. Governor Bullard, having a vote in the FOMC this year, apparently didn't join Hoenig in the dissent, despite the views he ventilated before the meeting. Two dissenters would have been bad for the Fed cohesion and image to the outside world at a difficult period in time for the Fed. So, we believe that chairman Bernanke might have prevented a second dissent by brokering a compromis, that might have included a retention of the phrase for this meeting, but a change lat the next meeting on the condition that economic and financial situation improves further, more in particular payrolls start to expand. We get maybe a better take on it when the Minutes of the FOMC meeting are published. The chances that the Fed will now start raising rates at the September meeting have greatly diminished. The implied fed fund future rates fell about 5 basis points for the December contract and 7.5 basis points further out in 2011.

Hoenig dissents

Kansas Fed governor Hoenig who “represents” the so-called hawkish wing inside the FOMC dissented again and now offered a more detailed explanation as to why he voted against. “it could lead to the buildup of financial imbalances and increase risks to longer-run macroeconomic and financial stability.

Very often in the past, a dissenter was followed in the next meeting by an actual change of policy in the direction of the dissenter. While that didn't happen at the March meeting, it seems highly likely that the entire Fed will follow Hoenig at a later stage, maybe at the April meeting. If that would occur and one applies the 6 month to the extended period, a rate hike would still be possible in one of the two latest meetings of 2010, notably November 2-3 or December 14. Of course, the Congressional elections in November complicate the timing of an eventual first rate hike and if the Fed would keep its forward-looking language beyond the April meeting, a rate change may even be postponed into 2011.

Further unwinding of exceptional measures

The FOMC confirms that its asset purchases program (Agency MBS and Agency papers) nears its completion (at the end of March 2010. It also confirms the closure of most of its special liquidity facilities with the exception of the TALF that is scheduled to close on June 30. Nothing new here, but nevertheless one could see these developments as a further unwinding of its exceptional crisis measures that brings the Fed closer towards a tightening of policy. More intriguing was the phrase that the “Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability”. The phrase follows the reference to the end of the asset purchases. Does that mean the Fed may resume its program if necessary? Or does it weaken its extended period of time reference in the sense that the Fed may act on rates if needed at any time?

Market reaction bullish

The money and fixed income market reacted on the more dovish statement as one would expect. Expectations for higher Interest rate, which had increased ahead of the meeting, were priced out. In the T-Note/bond market, yields dropped between 3 and 5 basis points, the belly outperforming. The implied Dec FF rate fell 5 ticks, 2011 FF rates slightly more. Equities (S&P) gained on the day and closed at the intra-day highs (+0.80%). The dollar lost some ground to the euro and yen, but the moves were technically insignificant.

Disclaimer: This non-exhaustive information is based on short-term forecasts for expected developments on the financial markets. KBC Bank cannot guarantee that these forecasts will materialize and cannot be held liable in any way for direct or consequential loss arising from any use of this document or its content. The document is not intended as personalized investment advice and does not constitute a recommendation to buy, sell or hold investments described herein. Although information has been obtained from and is based upon sources KBC believes to be reliable, KBC does not guarantee the accuracy of this information, which may be incomplete or condensed. All opinions and estimates constitute a KBC judgment as of the data of the report and are subject to change without notice.