FOMC: Growth Concerns Return

Overview: This afternoon Fed Chairman, Bernanke held the first part of his semiannual report to Congress in the Senate. Generally, the testimony was slightly softer than was expected by the market. It included no hints that the Fed is about to reverse monetary policy anytime soon. It also suggested that the central bank is now equally concerned about growth and inflation, leaving it in a neutral position. In summary, this indicates that interest rates are likely to remain on hold for a longer period of time.

Details: The June monetary policy statement tended towards inflation concerns slightly outweighing growth concerns; this bias was nowhere to be found in today's testimony.

Growth concerns were scaled up. In the June statement the Federal Open Market Committee (FOMC) noted that "Although downside risks to growth remain, they appear to have diminished somewhat". In today's testimony this was changed to "significant downside risks to the outlook for growth".

However, the language used about inflation was quite similar to that used in June's statement. Today Bernanke noted that "upside risks to the inflation outlook have intensified lately", which more closely resembles a phrase from the June statement: "upside risks to inflation and inflation expectations have increased".

Generally, the testimony suggests that the downside risks to growth have increased more than the upside risks to inflation have. This implies that the risk to growth and inflation are back on the same footing.

The monetary policy report also included revised economic projections. For 2008 the Q4/Q4 real GDP forecast was revised up from 0.3-1.2% to 1.0-1.6%. Importantly, this only reflects that the economy has been doing better than expected during H1 and not that the prospects for H2 have improved. When assuming 2% q/q AR GDP growth in Q2, the revised forecast is consistent with an average growth rate over H2 of 1.0-2.2% q/q AR. However, back at the April meeting, when a mild contraction in real GDP during H1 was expected, the implicit H2 forecast would have been in the 1.1-3.1% q/q AR range (assuming a contraction of 1% q/q AR in Q1 and Q2). The GDP forecast for 2009 was left unchanged.

Despite the recent sharp move up in the unemployment rate to 5.5%, the projection for 2008 was unchanged at 5.5-5.7%. In our view, this seems oddly low compared to the outlook for growth being well below potential in H2.

Not surprisingly, the headline PCE inflation forecast for 2008 was revised up, reflecting the continued rise in commodity prices. Importantly though, the projection for PCE core inflation remained unchanged at 2.2- 2.4%. Inflation forecasts for 2009 and 2010 only saw some minor changes.

Assessment & Outlook: We maintain our view that the growth outlook is too troubled to allow the FOMC to hike interest rates any time soon. This is also why we believe that the bond market is much more fairly priced now than it was just a few weeks ago, ahead of the June meeting. Following today's testimony, only a 50% probability of a Fed hike this year is being priced in.

Several negative factors (high energy and food inflation, credit tightening, contracting housing market) will remain in the equation in the coming quarters and we do not expect a sustainable recovery to materialise before late H1 next year. Hence, a normalisation of monetary policy is not likely to begin before mid-2009.

That said, high inflation remains a risk. In that respect, it will still be important to keep a close eye on longterm inflation expectations. If persistent signs of erosion materialise, these could potentially lead the Fed to deviate from its usual behaviour and tighten policy much earlier than it normally does. However, with the current, renewed financial jitters, we think the risk of such a scenario has clearly diminished.

Danske Bank

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