Thursday, June 23, 2011

No surprises from the Fed

There were no surprises in the press release from the US Federal Reserve this morning. All comments were consistent with recent press releases and Chairman Ben Bernanke’s speech two weeks ago.

The Federal Open Market Committee (FOMC) acknowledged the slower than expected pace of the economic recovery and weaker than expected labour market indicators. They also acknowledge the likely temporary nature of some of the factors (higher commodity prices and supply disruptions following the Japan earthquake) that have contributed to the recent weakness.

They expect the pace of activity to recover later this year, as we do, but they have lowered their GDP forecast for 2011 to a range of 2.7-2.9%. This is down from the April forecast of 3.1-3.3%, but still higher than our 2.5% expectation. Unemployment is expected to finish the year in the range 8.6-8.9%, up from 8.4-8.7%.

At the same time they forecast inflation to be slightly higher in 2011 with the annual increase in the core personal consumption expenditure (PCE) deflator expected to be in the range 1.5 - 1.8%. (Hmm…how long before we start worrying about stagflation?). That revised inflation forecast is up from a range of 1.3-1.6%. It is this turnaround in the core inflation indicators that is the deal breaker for any further quantitative easing. See the post below on why we don’t expect to see QE3 anytime soon.

Most importantly today there were no changes to key monetary policy messages. The FOMC continues to expect economic conditions to “warrant exceptionally low levels for the federal funds rate for an extended period”. QE2 will be completed this month and the Fed will continue to reinvest principal repayments from its security holdings, maintaining its balance sheet position.

Stopping reinvesting principal will be the first step towards tightening and will most likely happen about the time the Committee drops its “extended period” comment. In our view, that’s still a 2012 story.