Thoughts on the FOMC: Ten Points

I. The Federal Reserve Open Market Committee holds a two-day meeting this week, with the outcome anticipated near 2:15 pm on Wednesday, January 28. There is little doubt that the Fed funds target of 0-25 bp will be retained. The accompanying statement will receive the market’s full attention.

II. The data since the mid-Dec FOMC meeting has been dreadful and this will prevent a substantive change in the Fed’s assessment. Labor market conditions have continued to deteriorate. Consumer spending, business investment and industrial production figures are poor. The outlook for continued weakening of economic activity will be retained.

III. Inflationary pressures continue to diminish. In December, the FOMC said that it expected inflation to moderate further in coming quarters. Although most measures of price pressures have moderated, inflation expectations appear to have stopped falling. Consider that at the conclusion of the FOMC meeting on Dec 16, the five-year/five-year forward, which Fed officials (and ECB officials) have cited as a measure of inflation expectations, implied an expected inflation rate of about 60 bp. On the eve of this week’s FOMC meeting it is near 150 bp.

IV. In December, the FOMC reiterated its intentions to utilize other measures to stimulate the economy such as its purchases of agency debt and mortgage-backed securities. It also said it was evaluating the possibility of buying long-dated Treasury securities. The market is looking for at least an update on this point. Treasuries initially rallied on the news, but yields have backed up since the start of the month and 10 and 30 year Treasury yields are near their highest levels since the last FOMC meeting.

V. Fed officials have been particularly circumspect in terms of specifics about what maturities they were thinking about, though in the past, the 3-year to 6-year sector was suggested. However, the market is well aware that back in late 2002 through mid-2003, Bernanke, as a Fed governor, had suggested the possibility of increased outright purchases of long-dated Treasuries and nothing ever transpired. This prompts some concern that if the Fed does not buy Treasuries then it loses some credibility and erodes confidence and if it does buy Treasuries, then it risks disrupting the market amid talk from some large institutional investors that the US government debt market is already showing some characteristics of a bubble.

VI. There has also been some discussion of the Federal Reserve adopting a formal inflation target. Although Bernanke has long been sympathetic to it, he faced opposition among some of the Governors, including Vice Chairman Kohn. However, as a tool to combat deflation expectations, a formal inflation target is thought to be potentially helpful. Nevertheless, it seems too early for the Fed to announce one and it would likely not be announced at an FOMC meeting.

VII. With the Fed rate near zero and the Federal Reserve relying on extraordinary measures to support the economy and financial markets, the role of the regional presidents has been diminished. This is prompting some consternation by several regional presidents. The institutional arrangement between the Board of Governors and the regional presidents took several decades to evolve and this crisis is threatening that modus vivendi. This tension is below the surface and not much of a market factor at the moment, but it does suggest that after the crisis is over, there may be scope for some institutional reforms at the Federal Reserve itself.

VIII. The differences between the Federal Reserve and the ECB are significantly greater than most market participants appear to appreciate. Most of the contrasts have focused on aspects that we suspect are more superficial than material. Some times observers have over-emphasized the fact that the Fed looks at core inflation and the ECB focuses on headline inflation. Yet the Fed looks at several measures of inflation and inflation expectations some of which are headline rates, like the Treasury’s Inflation Protected Securities. Some times observers have over-emphasized the significance of the ECB’s formal inflation target. Fed officials have talked about their “comfort zone” for inflation which is like an informal target, while the ECB has consistently missed its formal target, making it more like an informal target.

IX. There are key differences between the Federal Reserve and ECB. In terms of structure, the Federal Reserve has a large central board and a relatively weak voice for the regional Fed presidents. In contrast, the ECB has a weaker central board and an apparently larger role for the national central bank governors. The bigger difference was hinted at by ECB member and Luxembourg central bank governor Mersch. The ECB may not have the policy levers at its disposal to engage in quantitative easing. If it were to buy bonds with newly printed euros, whose bonds would it buy and how is the decision to be made? There are no European assets only national assets. This is one of the institutional consequences of having monetary union without political union. Simply put under the current interpretation of its charters, the ECB may simply not have the tools at its disposal to explore non-conventional policy prescriptions which other central banks like the Federal Reserve, Bank of England and Bank of Japan are either considering or executing.

X. Countries like the US, UK, and Japan have a distinct advantage over eurozone members insofar as the former are currency issuers in a way that Germany, France, Italy, Ireland, and Spain for example are not. Therein lies the rub. While the long-term inflationary implications of quantitative ease can be debated (though it is interesting to note that they have not materialized in Japan), those are second order issues, the inability or significant obstacles for the ECB may prevent them from addressing first order issues. This combined with the dramatic widening of interest spreads with the eurozone and talks of a break-up (which we believe is neither imminent nor inevitable) underscores our belief that talk of the euro replacing the dollar as the world’s chief reserve asset is grossly exaggerated. We continue to believe that the multi-year bull market for the euro is over and the risks of the euro returning to its birth rate in the high teens is the most likely scenario.