USA: FOMC Less Downbeat on Growth

• As expected, the FOMC has decided to keep the target range for the fed funds rate at 0.00- 0.25% and has left the size and scope of the Fed's security purchase programmes unchanged. The door was kept open for further quantitative easing if it should become necessary.
• The FOMC has become slightly less downbeat on growth and sees some easing in financial market conditions. Nevertheless, the statement repeated that the fed funds rate will be kept at exceptional low levels for an extended period and that there are still some risks that inflation could fall below the Fed's comfort zone for some time.
• The yield curve steepened following the statement, driven by an increase in 10-year yields. Going forward, we believe that markets are likely to question the ‘Fed cap' on longer-term Treasury yields. We expect 10-year yields to increase from here and the yield curve to steepen further.

Details: The FOMC has decided to leave the fed funds rate at the current target range of 0.00- 0.25% and leave the targets for purchases of MBS, GSE and Treasuries unchanged.

The statement is generally less downbeat on growth saying that "the pace of contraction appears to be somewhat slower" and that “household spending has shown signs of stabilisation”. Furthermore, the FOMC saw “some easing in financial market conditions”.

Nevertheless, the statement repeated that the fed funds rate will be kept at exceptionally low levels for an extended period and that there are some risks that inflation could fall below the Fed's comfort zone for some time. In addition, the door was kept open for a scale-up of the Fed's security purchase programmes, if this should become necessary further down the road.

Our general impression remains, therefore, that the fed funds target rate will be held unchanged for a long period of time.

Assessment and outlook: 10-year Treasury yields have already broken through the 3% upper limit of the range they have been trading in since February. With the lack of any indications of a scale-up in Fed purchases, the FOMC statement is likely to pave the way for the market to further question the ‘Fed cap' on Treasury yields. In our view, the FOMC's main focus is not Treasury rates but rather private sector interest rates, especially mortgage rates. Therefore, we do not believe that there is a clear cap on long-term Treasury yields as long as credit spreads are narrowing and mortgage rates are held in check.

We therefore expect 10-year yields to head higher along with the improvement in economic indicators and financial conditions. The move higher could be quite drastic and we would not be surprised to see a 30-40bp increase, with a few stops on the way. This is likely to result in a further steepening of the yield curve as the short end of the curve will remain straight-jacketed for a while yet.

The recession has led to a huge output gap in the economy and the unemployment rate has spiked to a level way above the NAIRU. Applying standard Taylor rules would suggest that the Fed should keep interest rates on hold at least throughout 2010. While we believe that the Fed could choose to move away from the zero bound before that, rate hikes are likely to be off the agenda until the economy has returned convincingly to trend growth and unemployment has peaked.

Current statement

Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract, though the pace of contraction appears to be somewhat slower. Household spending has shown signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit. Weak sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories, fixed investment, and staffing. Although the economic outlook has improved modestly since the March meeting, partly reflecting some easing of financial market conditions, economic activity is likely to remain weak for a time. Nonetheless, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of financial and economic developments.

Previous statement

Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract. Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession. Although the near-term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve's balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of evolving financial and economic developments.

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

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