FOMC: Going Neutral

Daily Forex Fundamentals | Written by Danske Bank | Sep 17 08 06:01 GMT |

Overview: Last night, the Federal Open Market Committee (FOMC) decided to leave its policy rate unchanged at 2%, disappointing markets which were discounting a 90% probability of a rate cut. The statement shows that the Fed has now adopted a completely neutral stance, leaving the door open for any necessary policy action depending on how the current situation develops. The decision was unanimous as Dallas Fed Governor Richard Fisher refrained from voting for an increase at the meeting.

The initial market reaction was a flattening of the curve with 2-year treasury yields rising 10-12bp and 10- year treasury yields up 6-8bp. Equities responded negatively to the disappointment but moved higher later in the session on rumours that the US treasury is considering taking the insurance company American International Group (AIG) under conservatorship.

Details: In the growth section of the statement the Fed recognises that strains on financial markets have increased significantly and that the labour market has weakened further. Where growth was previously described as having expanded in Q2, it is now described as having slowed recently. So the statement overall now creates a more downbeat impression on growth.

There was only one change in the inflation assessment compared to the previous meeting. Inflation expectations are no longer regarded as being high but are not described as having declined either. In fact they are simply omitted from the statement. We believe this situation creates an impression that the FOMC is slightly less worried about inflation risks.

The balance of risk is now completely neutral as the statement refers to both downside risks to growth and upside risks to inflation as of 'significant concern', leaving the door open for any necessary policy action depending on how the situation develops. Also the FOMC added the word "carefully" in the sentence: 'The committee will monitor economic and financial conditions carefully' which in our view is a signal that the Fed stands ready to act quickly if necessary. Disagreement within the committee seems to have diminished as the decision to keep rates unchanged was unanimous on this occasion.

Assessment & Outlook: In our view, the Federal Reserve has turned its focus to instruments other than the fed funds rate in an attempt to ease the stress in financial markets. Over the last two days the Fed has added US$ 120bn in overnight liquidity to money markets and has enhanced its liquidity facilities and expanded the list of collateral eligible in PDCF and TLSF programmes (for details see Flash Comment - USA: Lehman files for bankruptcy). In addition the FOMC is likely to have taken some comfort from the decline in prime mortgage rates following the nationalisation of Fannie Mae and Freddie Mac.

We reiterate our previous assessment that the FOMC will leave its monetary policy on hold well into next year. If the current fall-back in commodities prices proves sustainable, the moderation in inflation will continue in coming months and inflation expectations should remain contained. In combination with increasing slack in the labour market this should work to calm inflation fears. The economy is set to face substantial headwinds in coming quarters with a continuing housing correction, declining asset prices, tighter credit on the back of continued stress in financial markets and a negative growth payback as the tax rebate dissipates. In our view this suggests that monetary policy will be left on hold for a prolonged period, although if systemic risks increase further in coming days or weeks an emergency rate cut cannot be ruled out.

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

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