FOMC: More Neutral, but Still on Easing Bias

Overview:

As widely expected, the Federal Open Market Committee (FOMC) decided to lower the Fed funds rate and the discount rate by 25bp to 2.00 and 2.25%, respectively. Generally, the statement was more neutral in its language than the previous one, but the committee has kept the door open for further cuts.

Again this time, there were widespread signs of disagreement about the decision. Unsurprisingly, Richard Fisher and Charles Plosser once again voted against the decision preferring no change in the Fed funds rate. Moreover, only four out of twelve district banks applied for a corresponding 25bp cut in the discount rate. That said, this is not much different from the previous meeting. This suggests that the majority of members are still predominantly concerned about growth risks.

Market reaction:

Following the decision, bond yields fell across the curve. Initially, 2-year US-treasury yields declined roughly 12bp, while 10-year yields dropped by 9bp leaving the curve a bit steeper. The market now discounts around 25% probability of another 25bp cut at the June meeting. US equity markets retreated a bit and the dollar weakened slightly.

Details:

Generally, the FOMC remains concerned about downside risks to growth and expects economic activity to remain sluggish in the 'next few quarters'. Surprisingly, the committee did not acknowledge any improvement in financial conditions as it was restated that 'Financial markets remain under considerable stress'. This is an important indication that the FOMC still sees the markets as being very fragile.

Inflationary risks remain an important concern for the FOMC, which emphasised further the risk from rising energy and other commodity prices. On the other hand, the committee also acknowledged the improvement in core inflation readings over the recent two months. On balance this leaves the impression that the FOMC is marginally less concerned about inflation now than at the March meeting.

The forward looking language was more neutral. First of all the committee writes that 'policy has been eased substantially'. Moreover, the sentence of 'acting in a timely manner' is removed from the text. This indicates that monetary easing is not on autopilot and that the FOMC is very close to halting the easing cycle. Importantly though, only growth - not inflation risks - is mentioned in the forward looking paragraph, thereby signalling that downside risks to growth remain the predominant concern for most members.

Assessment & Outlook:

As we wrote ahead of the meeting (see Flash Comment - FOMC: Preview of policy meeting) we would reconsider our Fed funds forecast following the meeting. Our three months' forecast of 1.50% seems a notch too high on back of the improving financial market conditions. That said we remain reluctant to call the FOMC on a firm hold already, as we expect incoming data to weaken further ahead of the June meeting and financial markets remain fragile.

The central bank remains sensitive to negative data surprises, but in particular to a renewed worsening of the financial conditions. Hence, we keep the profile of our forecast unchanged, but up our three month forecast from 1.50% to 1.75%. Hence, we still forecast a further (terminal) 25bp cut at the June meeting, but retain our view that the Fed will be on hold at 1.75% in H2 to assess the impact of the fiscal stimulus package and the substantial monetary easing. The short term risk to this view is that the Fed is already on hold and will not cut at the June meeting. In the longer term, the risk is that the soft patch that we expect to mature around New York as the fiscal boost peters out, could be severe enough to restart the easing cycle.

Current statement:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 2 percent.

Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labour markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected levelling out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Previous statement:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 2.25 percent.

Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labour markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.

Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected levelling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully.

Today's policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability.

Danske Bank
http://www.danskebank.com/danskeresearch

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