How Today's FOMC Statement Differs from the August 9 Statement?

By: Ashraf Laidi | Wed, Sep 21, 2005
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The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 3- 3/4 percent.

The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Aggregate spending, despite high energy prices, appears to have strengthened since late winter, and labor market conditions continue to improve gradually. Core Output appeared poised to continue growing at a good pace before the tragic toll of Hurricane Katrina. The widespread devastation in the Gulf region, the associated dislocation of economic activity, and the boost to energy prices imply that spending, production, and employment will be set back in the near term. In addition to elevating premiums for some energy products, the disruption to the production and refining infrastructure may add to energy price volatility.

While these unfortunate developments have increased uncertainty about near-term economic performance, it is the Committee's view that they do not pose a more persistent threat. Rather, monetary policy accommodation, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Higher energy and other costs have the potential to add to inflation pressures. However, core inflation has been relatively low in recent months and longer-term inflation expectations remain well contained, but pressures on inflation have stayed elevated.

The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.

In its 11th interest rate hike of the present tightening cycle, the Federal Open Market Committee stuck with the script of the last 15 months, of gradual interest rate hikes and a balanced economic assessment. The Fed's decision to raise rates in the face of its acknowledgement of the "associated dislocation of economic activity, and the boost to energy prices imply" of Hurricane Katrina implies that the central bank deem these as mostly transitionary.

Fed Action & Words: 20 months elapsed and little change

FOMC Meeting Balance of Econ Risks Balance of Price Risks Policy Accommodation Labor Mkts. Reference
5/6/2003 Roughly Equal Negative None None
6/25/2003 Roughly Equal Negative None None
8/12/2003 Roughly Equal Negative Considerable Period Mixed
9/16/2003 Roughly Equal Negative Considerable Period Weakening
10/28/2003 Roughly Equal Negative Considerable Period Stabilizing
12/9/2003 Roughly Equal Almost Equal Considerable Period Improving modestly
1/28/2004 Roughly Equal Almost Equal Patient in removing it Improvement
3/16/2004 Roughly Equal Almost Equal Patient in removing it New hiring lagged
5/4/2004 Roughly Equal LT Inflation Contained Removed Measurably Hiring Picked up
6/30/2004 Roughly Equal Roughly Equal Removed Measurably Improved
8/10/2004 Roughly Equal Roughly Equal Removed Measurably Improvmt. slowed
9/21/2004 Roughly Equal Roughly Equal Removed Measurably Modst. improvmt.
11/10/2004 Roughly Equal Roughly Equal Removed Measurably Improved
12/14/2004 Roughly Equal Roughly Equal Removed Measurably Improved gradually
2/2/2005 Roughly Equal Roughly Equal Removed Measurably Improved gradually
3/22/2005 Roughly Equal Roughly Equal * Removed Measurably Improved gradually
5/3/2005 Roughly Equal Roughly Equal * Removed Measurably Improved gradually
6/30/05 Roughly Equal Roughly Equal* Removed Measurably Improved gradually
8/10/2005 Roughly Equal Roughly Equal * Removed Measurably Improved gradually
9/20/2005 Roughly Equal Roughly Equal * Removed Measurably Improved gradually

The fact that the Fed deems "core inflation has been relatively low in recent months and longer-term inflation expectations remain contained" despite the surging volatility in energy prices, means the central bank is highly confident of the accommodative role of its overall monetary policy.

Indeed, despite the 11 rate hikes of the past 15 months, liquidity remains plentiful. The red graph in the chart below shows that the month-to-month increase in money supply (M2) has fallen over the past few years. This year's average monthly growth of M2 liquidity stands at 0.2%, well below the 0.5%, 0.4% and 0.5% in 2004, 2003 and 2002. This clearly suggests that Fed's tightening campaign is aimed at normalizing interest rates towards a neutral level - most likely at a 4.00%-4.25% fed funds target, but without hindering economic growth, hence, maintaining an "accommodative" policy via generous M2 liquidity.

Moreover, our rationale for a pause in monetary policy is underlined by the emerging of a slowing US consumer in the 2 years preceding the Hurricane. The next chart shows that the contribution of US consumers and companies into GDP growth to have slowed invariably. The slowdown in consumers' contribution to GDP from 4.1% in Q3 2003 to 2.1% in Q2 2005 occurred well before the 30% increase in gasoline prices between July and mid September. Falling consumer confidence (tumbling Univ of Michigan), increased jobless claims and unemployment which are not guaranteed to be filled are factors that are cause for a Fed pause. It may be argued that a Fed pause today might have run the risk of bringing the Fed it behind inflation especially that there is no scheduled meeting in October. But as we argued over the past year, the contractionary risks of higher oil are increasingly shadowing the inflationary risks of oil. And the aforementioned spillover effects of Katrina are likely to be distributed over the next few months, especially when the economy has been stretched thin by the factors seen in the chart below.

FX Impact

The Fed's ruling that the hurricane impact did "not pose a more persistent threat" 3 weeks after the hurricane implies that the central bank shall continue to deliver its measured tightening policy into year's end. This would normally be a dollar positive as it expands the currency's yield superiority relative to the Eurozone, Canada, Japan and Switzerland while narrowing the yield disadvantage relative to Australia and the UK. But we should remind readers the dollar began selling-off in the first week of July - about 2 weeks after Fed Chairman's positive testimony signaled a continuous tightening in each of the year's remaining scheduled meetings.

Nevertheless, this time the dollar could get a deja-vu of May 2005 - when uncertainty in the EU Constitution coupled with continued Fed tightening produced a convincing dollar rally. As long as the deadlock in German elections remains, there exists the potential for the dollar to break below the $1.21 figure and test the $1.2030 target into the figure by end month. A compromise between Chancellor Schroeder and CDU leader Angela Merkel would be more helpful for the Euro than a "repeat" of the elections--in which case political disarray should lead to the break of the $1.20 and onto $1.1960.


 

Ashraf Laidi

Author: Ashraf Laidi

Ashraf Laidi
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