Fed Dilema Resolved; Treasury's Just Beginning

Prior the US April jobs data, the Fed funds futures had been straddling the fence, with a roughly 50/50 chance of a hike/pause. The weaker than expected job growth resolves the dilemma and shifts the odds convincingly toward a pause. The Federal Reserve will signal to the market next week that it is prepared to pause, barring significant surprises in the next string of data.

As has been the pattern in recent months, the FOMC meeting and rate decision are largely non-events. The market remains confident of a 25 bp rate hike on Wednesday May 10. The uncertainty lies with the accompanying statement.

There are three general parts of the Fed’s statement. The first part assesses the trajectory of growth. The FOMC expects the economy to moderate from the above trend growth reported in Q1 (and incidentally appears to be subject to an upward revision). Although the non-farm payrolls growth was less than expected, the fact that hours worked rose actually points to a net contribution to output, suggesting along with the recent ISM data, that the economy has begun Q2 on strong footing. Nevertheless, high frequency data has a great deal of noise and the Fed is unlikely to change its assessment.

The second part assesses price pressures. The Fed views inflation as contained, but sees upside risks posed by resource utilization, and pass through form higher energy and commodity prices. There is even less a reason for the Fed to substantively alter its inflation stance than its growth outlook.

The third part of the Fed’s statement offers some policy guidance. The wording of this part is the most likely to be modified. It is here that the Fed will prepare the market for the likely pause in June. However, the key message the Fed wants to drive home is that it is neither hawkish nor dovish, but data dependent. Under this data dependence regime, the key is not how the data compares with consensus forecasts, but the Fed’s forecasts. Surely we have to believe that May data and preliminary June data will be important to the FOMC’s making at the June 29 FOMC meeting than the April data.

The statement will also need to underscore what Bernanke told the Joint Economic Committee of Congress recently; namely that a pause not necessarily signal an end to the cycle. The market will disregard this at its own jeopardy. We continue to believe the resilience of the economy and the risk of upward pressure on the Fed funds rate will compel the Fed to raise rates again in H2. We stick with out forecast of a 5.5% Fed funds target before year end.

Treasury’s Challenge

While the Fed’s challenge of preparing the market for a pause appears to be increasingly secure, the Treasury’s challenge is likely to move to the center stage. Some time next week—date still unknown—the Treasury will issue its “Report to Congress on International Economic and Exchange Rate Policies.”

The focus is on whether the US formally cites China as a manipulator in the foreign exchange market. One investment bank reportedly surveyed clients and found that 2/3 did not expect China to be cited. Analysts at another major bank warned that citing China would inflame protectionist sentiment. Analysts at yet another bank argued that the US prefers a multilateral approach to the yuan and are content with the G7/IMF call.

These views seem to rely on an improper level of analysis and misunderstand the nature of US politics. The US does not have a parliamentary system, under which the executive and legislative functions are much more conjoined than experienced under the presidential system. Citing China has more to do with the long-running tension between the US legislative branch and the executive branch. The Graham-Schumer bill and other such protectionist bills and rhetoric from Congress were a wake up call for the Bush Administration. Congress was on the verge preempting the White House in setting the US-China agenda.