Important FOMC Decision, Is FOMC Ready to Shape its Exit Strategy?
The FOMC has begun its 2-day meeting on interest rates and while this meeting will prove to be an important one, it may not be pivotal as the Fed is likely to keep a few cards up its sleeve in terms of describing the next steps that will be taken by the central bank.
The important questions to ask are:
What do we hear about the end of QE2?
What do we hear about the Fed's balance sheet?
How does the FOMC see inflation expectations and growth projections?
Any hints as to when the FOMC will raise interest rates?
The answer to these questions will decide whether we have an overall hawkish message or one that is more dovish.
1. End of Quantitative Easing 2
The market is expecting an answer to the first question, and we will get updated forecasts on both inflation and growth - answering our third question. The Fed will most likely reserve its judgement on questions two and four, as they don't want to be pigeon-holed into policy action that they may have to change as more data comes in about the second quarter.
In regards to quantitative easing, it seems quite likely that the Fed will see its buying of long-term Treasuries through to completion - that means the full amount of $600 billion that is scheduled to finish at the end of June.
Any move to end QE2 sooner would be a big USD positive while any talk of extending QE2 would be a large USD negative.
The status quo position currently is that while the economy is improving, according to the doves on the FOMC - Bernanke, Janet Yellen, William Dudley - the need for monetary support is still there, there is no need to cut the program short, and the Fed should see it through to completion. That outcome is mildly USD negative, as it shows that the Fed has not changed its mind since last fall about conditions in the real economy to warrant a change in course. For the USD, its still much better than extending QE2 which would mean that the US economy recovery was still not self-sustainable enough to take away this pillar of support. With QE3, the Fed's goal would be to buy more Treasury bonds in order to lower rates on loans and push up stock prices. That could spur spending and invigorate the economy, but at a price of a big hit to the USD and further stoking of commodity inflation.
Interest Rate Expectations Drive USD to 3-Year Low
With the ECB hiking rates, developing countries tightening policy, and other central banks like the Bank of England, Bank of Canada, and the Reserve Bank of Australia needing to hike rates as we go through 2011, the Fed is at the back of the line in terms of its monetary policy.
Widening interest rate differentials have been working against the USD for a while now, the Fed's ultra loose monetary policy is not a new story, but it is holding some extra immediacy right now as the USD index hit a 3-year low this week.
Here's a daily chart of the USD index with the Dollar falling below the 74 level recently.
The USD's direction therefore will be decided by the Fed, and for the first time the FOMC statement will be followed by a press conference, so Bernanke will be able to get his message directly to the market and the public.
2. Next, What Happens to Fed Balance Sheet After the End of QE2?
The message that Bernanke has to transmit is what the Fed's next step will be following the end of the QE2 program. The main impetus being on what happens with interest rates (any chance of a rate hike this year?) but more importantly for the short to medium term what the Fed will decide to do with its balance sheet which has increased to a figure of $2.3 trillion.
First the Fed has to decide what to do with the Treasuries it has on its balance sheet. As Treasurys mature, the Fed has been re-investing them, keeping the Fed's balance sheet constant (and growing due to the buying of Treasurys as part of QE2).
The Fed could let the maturing Treasuries come off its balance sheet, thereby shrinking it, but that would in effect tighten monetary policy. As Treasurys mature, the Fed recoups its principle, which means money comes out of the economy and back into the central bank.
The likeliest scenario is that the Fed will not want to take this step just yet, and will announce that after the end of QE2, it will continue to re-invest maturing Treasuries, thereby it wont be easing or tightening policy, but keeping it level as the end of QE2 is digested by bond and equity, and other financial markets.
We would have to see the policy of re-investing maturing bonds end before the Fed decides to sell more of its Treasurys and further shrink its balance sheet by selling its stockpile of mortgage-backed securities (MBS). Bernanke is likely to be vague on the topic of MBS, but we should get some insight into when the Fed may decide to stop re-investing maturing bonds.
For Wednesday the keys then are:
Likeliest scenario is no more easing, but no tightening either.
A surprise call to shrink balance sheet (not to re-invest maturing Treasurys) would be USD positive.
End of re-investment another 2+ months out.
Lack of specifics here could cause market to think there is no tightening coming, and punish USD.
3. How does the FOMC see inflation expectations and growth projections?
The Fed will be releasing updated forecasts on growth, the unemployment rate, and tomorrow. We will have a look at the data they are using to come to their conclusions.
Here's a look at their January figures:
The economy grew less than expected in the 1st quarter which will cause the FOMC to revise down their January forecasts for GDP for this year.
The FOMC may acknowledge an improving labor market, and revise down its unemployment rate forecasts.
At the same time, the jump in oil prices has caused a spike in headline inflation, likely bringing up the inflation forecasts as well.
The economy has shown some resiliency, despite a weaker 1st quarter (expected to come in at 1.9%), as a pick up in jobs and strong consumer spending fueled hopes that the private sector could "take the baton" from government and central bank stimulus and that the recovery could become self-sustaining.
The doves on the Fed still see the unemployment rate at too high a level, and by focusing on "core" inflation which strips out energy and food prices, they believe that the underlying rate of inflation is low. The doves want to make sure they have slayed deflation before they move onto the threat of inflation.
We expect the important language in the Fed's statement that conditions "warrant exceptionally low levels for the federal funds rate for an extended period" and the "measures of underlying inflation continue to be somewhat low" to stay.
It may be another 2-3 months before the Fed decides to remove the language calling for rates to stay low, as that would give the market a 5-6 month countdown from which the Fed would be interested in raising interest rates. First, the Fed wants to transition from QE2 to neutral, and then it will begin to address raising interest rates.
The Fed has some other tools still at its disposal to try and tame inflation without resorting to raising the benchmark interest rate.
4. Options For Battling Inflation That Are Not Raising the Federal Funds Rate
1. The Fed could raise the rate it charges banks for emergency loans. That rate, called the discount rate, is at 0.75%. It won't impact consumers and businesses but it does signal to banks and other financial institutions that the Fed may move its federal funds rate soon as well.
2. The Fed can raise the interest rate it pays banks on money they leave at the central bank, or their "excess reserves". This would tighten credit as it encourages banks to keep their money at the Fed rather than lend it out. Therefore, this step would raise rates tied to commercial banks' prime rate and affect many consumer loans. Currently this rate is at 0.25%.
The Fed has put some importance on the use of this tool in order to battle inflation. The NY Fed's Dudley, a leading member of thee FOMC, has touted it.
From Bloomberg: "Congress granted the Fed this ability in 2008, and Chairman Ben S. Bernanke, Vice Chairman Janet Yellen and New York Fed President William Dudley have all cited it as a main reason why they'll be able to keep the U.S. economy from overheating after pumping record amounts of cash into the financial system.The amount of excess reserves climbed to $1.47 trillion this month from $991 billion at year-end and $2.2 billion at the start of 2007, Fed data show.
The effectiveness of using interest on reserves, or IOR, as a main policy tool may depend on how closely the federal funds rate, or overnight inter-bank lending rate, follows its movements.
"The big unknown is how tight the spread between the IOR and effective fed funds rate will be," said Dino Kos, a managing director at economic-research firm Hamiltonian Associates Ltd. in New York. "If the fed funds rate trades at a stable, and preferably narrow, discount to the IOR, then tightening policy through the IOR is doable. But a wide and unstable spread undermines the strategy."
3. Another option to tighten credit would be to shrink the Fed's balance sheet, what we discussed earlier in the article, by selling its securities outright, or by doing "reverse repurchase agreements" in which the Fed sells securities from the Fed's portfolio with an agreement to buy them back later.
Outlook: Forecast for Fed's Actions
The FOMC has to walk a fine line tomorrow. It need to wind down its latest bout of quantitative easing, and prepare the landscape for an exit strategy from its ultra loose monetary policy. While the threat of inflation is gaining, the Fed, led by its more dovish members, seems to putting itself on a gradual approach towards normalization. An aggressive campaign to tighten credit and send a signal that an interest rate increase could come this year is less likely.
Tomorrow, we should get an announcement that Fed will to the end of QE2 in June.
End of reinvestment 2+ months later (Aug/Sept).
Drop extended period language a months or 2 later (Sept./Oct)
Raise rates in early to mid-2012 (Feb-Apr '12).
If Bernanke is vague about an exit strategy, and about answering questions about when the Fed may take steps such as shrinking its balance sheet, raising the interest rate given to banks to hold reserves with the Fed, the end of re-investing Treasuries, and the prospect for raising the key benchmark interest rate it could put the USD into a defensive mode as it makes traders think that the Fed will continue to fall behind the curve in battling inflation.
However, some clear signals on exit strategy would give the USD a boost. Pricing in interest rate expectations and yield differentials, as it has been the past few moths - has continued to weight heavily on the US Dollar. The ECB has begun its policy tightening cycle with a rate hike in early April, while a similar move by the Fed is not expected till early 2012. With the doves in the FOMC seeming to have won the skirmish recently, meaning stimulus will be removed with a gradual policy rather than an aggressive one, this scenario as we mentioned above carries a smaller probability.
http://www.actionforex.com/analysis/daily-forex-fundamentals/important-fomc-decision,-is-fomc-ready-to-shape-its-exit-strategy%3f-20110426138571/
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