Flash Comment: FOMC Preview

• The Fed is expected to keep rates and asset purchase programmes unchanged. Further normalisation of the discount rate spread will not form part of the decision.
• Language on growth and inflation is likely to be little changed but more optimistic on the labour market.
• Bias will remain soft, with a restatement of the “extended period” phrase. We do not expect other members to join Hoenig in voting against this terminology.
• Termination of asset purchase programmes by end-March will be confirmed. It remains premature for the Fed to begin absorbing excess liquidity.
• Market reaction is likely to be muted.

Activity

We see increasing signs of a self-sustained recovery with relatively solid progress in consumer spending and more developed indications of an imminent turnaround in the labour market. Still, recent significant weakness in housing is likely to create concern. Financial conditions are broadly unchanged with signs that credit tightening is slowing. We expect only minor changes to the growth section, including a more optimistic assessment of the labour market and household sector but a more downbeat message on housing. Overall, the focus will remain on slack in the economy with an unchanged outlook suggesting a gradual return to higher levels of resource utilisation.

Inflation

Core inflation has fallen below the Fed's comfort zone and remains on a downward trend, reinforced by huge slack in the economy. Since the last meeting, both market and household expectations of long-term inflation trends have edged slightly lower, while commodity prices are broadly unchanged. The FOMC is likely to reiterate its expectation that inflation will remain subdued for some time, referring to enormous resource slack and stable inflation expectations.

Bias and policy outlook:

While recent communication does not indicate an imminent change in outlook for monetary policy, a WSJ article has recently suggested that the Fed has begun warming up to a change in language. Although outlook risks appear slightly more balanced, major concerns remain deflationary possibilities and an anaemic recovery. The FOMC is expected to retain its key phrase on “exceptionally low levels of the federal funds rate for an extended period.” However, it will signal that further asset purchases are no longer a consideration, by omitting or modifying the phrase: ‘evaluating purchases of securities'. We expect Hoenig to register his dissent concerning the statement. Generally, the bias will remain soft, but slightly less so than previously.

Market pricing: The market is currently pricing an initial rate hike to 0.50% in December. We expect the statement to surprise little and see only a muted market reaction. Our main scenario involves only one dissenter, but in the event of two members voting against the decision, we see a risk of higher yields and flatter curves.

FOMC key statements

Bernanke (neutral, voter) February 24 (Semi-annual testimony to Congress):

FOMC participants continue to anticipate a moderate pace of economic recovery, with economic growth of roughly 3 to 3-1/2 percent in 2010 and 3-1/2 to 4-1/2 percent in 2011. Consistent with moderate economic growth, participants expect the unemployment rate to decline only slowly, to a range of roughly 6-1/2 to 7-1/2 percent by the end of 2012, still well above their estimate of the long-run sustainable rate of about 5 percent. Inflation is expected to remain subdued, with consumer prices rising at rates between 1 and 2 percent in 2010 through 2012. In the longer term, inflation is expected to be between 1-3/4 and 2 percent, the range that most FOMC participants judge to be consistent with the Federal Reserve's dual mandate of price stability and maximum employment.

Last week we announced that the maximum term of discount window loans ... would be returned to overnight for most banks ... [and] increased the discount rate by 25 basis points... These changes, like the closure of most of the special lending facilities earlier this month, are in response to the improved functioning of financial markets, which has reduced the need for extraordinary assistance from the Federal Reserve. These adjustments are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy, which remains about the same as it was at the time of the January meeting of the FOMC.

Extracts from FOMC minutes, January 26-27 meeting

Participants expected the economic recovery to continue, but most anticipated that the pickup in output and employment growth would be rather slow relative to past recoveries from deep recessions. A moderate pace of expansion would imply slow improvement in the labor market this year, with unemployment declining only gradually. Most participants again projected that the economy would grow somewhat more rapidly in 2011 and 2012, generating a more pronounced decline in the unemployment rate, as financial conditions and the availability of credit continue to improve

Participants agreed that underlying inflation currently was subdued and was likely to remain so for some time. Some noted the risk that, with output well below potential over the next couple of years, inflation could edge further below the rates they judged most consistent with the Federal Reserve's dual mandate for maximum employment and price stability; others, focusing on risks to inflation expectations and the challenge of removing monetary accommodation in a timely manner, saw inflation risks as tilted toward the upside, especially in the medium term.

The weakness in labor markets continued to be an important concern for the FOMC; moreover, the prospects for job growth remained an important source of uncertainty in the economic outlook, particularly in the outlook for consumer spending.

The Committee emphasized that it would continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets. Members recognized that references to "purchases" of securities would need to be modified as the completion of the asset purchase programs draws near. One member recommended that the FOMC replace the portion of the statement that indicates the Committee will evaluate its "purchases" of securities with an indication that the Committee will evaluate its "holdings" of securities. The change in wording would encompass the possibility that the Committee might decide, at some point, either to sell securities or to purchase additional securities.

Statement from January 26-27meeting

Information received since the Federal Open Market Committee met in December suggests that economic activity has continued to strengthen and that the deterioration in the labor market is abating. Household spending is expanding at a moderate rate but remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software appears to be picking up, but investment in structures is still contracting and employers remain reluctant to add to payrolls. Firms have brought inventory stocks into better alignment with sales. While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.

With substantial resource slack continuing to restrain cost pressures and with longer-term inflation expectations stable, inflation is likely to be subdued for some time.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. In order to promote a smooth transition in markets, the Committee is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter. The Committee will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets.

In light of improved functioning of financial markets, the Federal Reserve will be closing the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility on February 1, as previously announced. In addition, the temporary liquidity swap arrangements between the Federal Reserve and other central banks will expire on February 1. The Federal Reserve is in the process of winding down its Term Auction Facility: $50 billion in 28-day credit will be offered on February 8 and $25 billion in 28-day credit will be offered at the final auction on March 8. The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30 for loans backed by new-issue commercial mortgage-backed securities and March 31 for loans backed by all other types of collateral. The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh. Voting against the policy action was Thomas M. Hoenig, who believed that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted.

FOMC ornithology

Danske Bank
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