FOMC: Hawks and Doves in Bird-Fight

Overview: The minutes of the June 24-25 monetary policy meeting were released yesterday evening (July 16) at 20:00 CET. Following Bernanke's testimony to Congress on July 15-16, much of the information con-tained in the minutes was redundant. Most committee members probably felt more comfortable about the growth outlook back in June than they do now, as also indicated by Bernanke's testimony.

The most interesting information suggested by the minutes, was increasing evidence of disagreement be-tween the FOMC's hawks and doves. In several passages of the text the disagreement between members has been made exceptionally explicit, literally portraying a bird-fight between the committee's hawks and doves.

Details: The following excerpts appear to suggest substantial disagreements between members of the committee:

"Participants' views of the recent evidence on inflation expectations varied. Some noted that the increase was greatest for short-term survey measures of households' inflation expectations (...) those participants judged that underlying inflation trends had not risen nearly as much as anticipated. However, others saw the signs of a rise in inflation expectations as more broad-based and were concerned that this development could signal an erosion of confidence in the Committee's commitment to price stability ..."

"Some participants noted that certain measures of the real federal funds rate, especially those using actual or fore-casted headline inflation, were now negative, and very low by historical standards. In the view of these participants (...) some firming in policy would be appropriate very soon, if not at this meeting. However, other participants ob-served that the high level of risk spreads and the restricted availability of credit suggested that overall financial conditions were not especially accommodative; indeed, borrowing costs for many households and businesses were higher than they had been last summer."

Despite differences of opinion between the parties concerned, the minutes note that "... members believed that the next change in the stance of policy could well be an increase in the funds rate; indeed, one member thought that policy should be firmed at this meeting. However (...) the timing and magnitude of future policy actions was quite unclear." Obviously this suggests that the committee – at the time of its last meeting in June – was in fact beginning to position itself to hike interest rates, should conditions allow it. In our view, this is an important hint that the FOMC feels fundamentally inclined to reverse its monetary policy much earlier than suggested by historical standards. This reflects both the flipside of the insurance policy which provided the basis for the committee's very drastic easing of policy during the spring, as well as the FOMC's desire to avoid leaving interest rates too low for too long, which might instead create fresh imbalances in the financial system.

Assessment & Outlook: Significantly, however, financial conditions have deteriorated considerably since the June meeting. Although the minutes also mention significant downside risks to growth these risks have probably become even more significant for most members in view of recent financial turmoil. Therefore – as suggested by Bernanke's congressional testimony – we think the FOMC is unlikely to increase the fed funds rate anytime soon. We do not expect a normalisation of monetary policy to begin before mid-2009.

That said, high inflation remains a risk as demonstrated by yesterday's (July 16) CPI numbers for June. Consequently, it will still be important to keep a close eye on long-term 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, given current, renewed financial nervousness, we think the risk of such a scenario has clearly diminished. See also Flash Comment – FOMC: Growth con-cerns return (July 15, 2008) for more on Bernanke's testimony to Congress and the monetary policy out-look.

Danske Bank

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