June 23, 2010

One source of the dollar’s strength against the euro since late November has been a perception that the Fed will begin raising interest rates well ahead of the ECB.   If this premise were prescient, it should only be meaningful from a market standpoint if the onset of Fed tightening were six to nine months away.  If the Fed funds rate first gets raised at end-January 2011 and ECB tightening is delayed until July 2011, both moves are too far away for investors to care in November 2009 unless those investors incorrectly presumed that tightening would start a lot sooner at the Fed (say by mid-2010) and not happen at the ECB until six months or later than that. 

Investors know now that Fed tightening did not begin by the middle of 2010, but that’s not stopping them from the same dollar-supporting generalization.  In fact, the FOMC hasn’t even removed its conditional forecast that the funds rate will stay where it is for “an extended period of time.”  That almost surely implies no move until at least January 2011.  Today’s FOMC statement leaves additional clues suggesting that the Fed will not be raising rates even as late as then, however.

  • The overall economic assessment was downgraded to a recovery that’s “proceeding” from one where activity is “strengthening.”  The new sentence simply means the direction of GDP is upward.  Growth could limp forward at a greatly reduced 1% and still be said to be proceeding.  “Strengthening” implied rising GDP at an accelerating pace and with broader participation across regions and components of demand.  Housing starts were downgraded explicitly, and what seems to be an upward appraisal of the U.S. labor market really is not.  The prior statement observed that the labor market is beginning to improve, and the new one said the labor market is improving gradually.  Once a trend has begun, it cannot continue to begin.  One would hope that when the trend moves past its brief starting phase that it gathers momentum, but today’s statement notes that the rate of improvement is only gradual.  In truth, it’s hardly that other than the drop in the jobless rate.  Layoffs are just as heavy as they’ve been since December, and fewer private sector jobs were added in May than in April.
  • The statement retains the language of the past several statements about stable long-term inflation expectations and the likelihood of subdued inflation for some time and additionally notes that the one prior source of strain, commodity prices, is receding.
  • The statement downgrades the assessment of financial conditions from being supportive of growth to now on balance being “less supportive.”  This is the shift that wire services seized upon in their top headlines.
  • The reason given for the shift in financial conditions is attributed to “developments abroad.”  This is an extremely important point that casts doubt on the likelihood of a two-speed tightening of monetary policy among major advanced economy central banks.  The world is too interconnected.  Europe and Japan found that out when a U.S. housing market meltdown ricocheted back to them.  In a worst-case scenario for Europe, long-term U.S. interest rates and U.S. equities will head lower, and Fed tightening will be delayed. 

If Europe’s economy performs better than generally expected,  monetary tightening in the U.S. and Europe could still travel more similar paths than investors have assumed.  Indirect tax increases to trim deficits will boost reported inflation in Euroland, and ECB officials will want to showcase their vigilance against not allowing such a development to impact inflation expectations adversely.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

Tags: ,


Comments are closed.