FOMC Meeting: Speak Loudly And Carry A Small Stick

Daily Forex Fundamentals | Written by Wachovia Corporation | Jun 25 08 20:30 GMT |

As expected, the Federal Reserve left the federal funds rate unchanged at 2 percent at today's FOMC meeting. The wording in the Fed's statement is a touch more hawkish than in previous meetings and one member of the FOMC, Richard Fisher, president of the Dallas Fed, dissented in favor of raising interest rates.

The Fed is in a tough spot, with no clear good choices to make. Raising interest rates might help curb some of the fears about escalating inflation but would not likely have a material impact on actual inflation. Absent signs that a wage-price spiral has actually taken hold, a token quarter-point hike in the federal funds rate seems like a high risk/low return proposition.

Right now, the best option for the Fed is to speak loudly and carry a small stick. The text from today's FOMC meeting does just that. The statement starts with a clearly more positive assessment of the economy. Specifically, the Fed notes that "recent information indicates that overall economic activity continues to expand, partly reflecting some firming in household spending." The statement is right on the money and largely reflects stronger retail sales, which rose solidly in May and were revised up for the two previous months. While the Fed did not say it in this statement, they are readily aware that part of the recent strength in household spending is temporary and linked to the tax rebates.

The remainder of the first paragraph is similar to the previous meeting's statement, noting that "labor markets have softened further" and that "financial markets remain under considerable stress." We doubt that the Fed will begin to raise interest rates until these two factors have at least moderated to a point where they are neutral variables in the near-term outlook. In addition, the Fed added the recent "rise in energy prices" to its list of factors weighing on economic growth, joining "tight credit conditions" and "the ongoing housing contraction."

One other change worth noting is that the Fed slightly softened the wording on the housing situation to "ongoing housing contraction" from "deepening housing contraction." We noted in our June 12 Housing Chartbook that we were beginning to see some tentative signs that the housing market was bottoming out. The housing market is still contracting but sales in some of the most troubled markets, including some hard hit parts of Florida and California, have stopped falling.

The wording on inflation is clearly more hawkish than what we have seen in recent statements but the Fed gives no indication that they feel the inflation horse is already out of the barn. The statement notes that "the committee expects inflation to moderate later this year and next year." Moreover, they note that much of the heightened concern about inflation comes from continued increases in energy prices and increases in the prices of some other commodities, factors that are not directly within the Fed's control. Remember, the Fed cannot print oil or make it stop raining in the Midwest.

Keeping inflation expectations contained is the number one job for the Fed. If inflation expectations increase too dramatically, then the recent spike in food and energy prices will spill over into the prices of other goods and services. The Fed acknowledges that "some indicators of inflation expectations" have increased and that "uncertainty about the inflation outlook remains high." Those kind of statements are meant to reassure the financial markets that the Fed is cognizant of the inflation risks.

To really drive home the point, however, the Fed included a sentence at the end of the statement that succinctly summarized how conditions have changed over the past two months. "Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased." In addition, Richard Fisher dissented from the rest of the group, favoring to raise the federal funds rate at this meeting.

Summary & Conclusion

Our read on the policy statement is that the Fed feels monetary policy is currently right where they want it to be. We expect the federal funds rate to remain right where it is through the end of this year, or until the housing market bottoms and the credit markets firm up. The Fed will continue to speak loudly about the threat of inflation but they will continue to carry a small stick.

Wachovia Corporation
http://www.wachovia.com

Disclaimer: The information and opinions herein are for general information use only. Wachovia Corporation and its affiliates, including Wachovia Bank, N.A., do not guarantee their accuracy or completeness, nor does Wachovia Corporation or any of its affiliates, including Wachovia Bank, N.A., assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or any foreign exchange transaction, or as personalized investment advice. Securities and foreign exchange transactions are not FDIC-insured, are not bank-guaranteed, and may lose value.