Preview of FOMC

The Federal Reserve's last meeting of the year begins today and concludes tomorrow. We do not anticipate much change in the FOMC statement and even less of a change in the Fed funds target (or the discount rate, which at FT columnist suggests is part of a risk scenario that should be taken seriously).

Recent FOMC statements have come in three paragraphs. The first paragraph is a review of recent data. Here the Fed is likely to repeat what it noted last month, namely that "economic activity has continued to pick-up." This would come on the heels of course of a series of data, including inventory, trade, retail sales and the smallest job loss of the year, that is encouraging Street economists to revise upward Q4 GDP forecasts. There may be some tweaking of the wording to reflect some nuanced changes.

The second paragraph is the Fed's assessment of inflation. This paragraph in the Nov statement repeated verbatim the Oct statement. The Fed's assessment is unlikely to change substantially. The slack resource utilization (labor markets and industrial capacity usage) will dampen price pressures. Inflation expectations are stable. The Fed expects prices to be subdued for some time.

That said, there are some developments that might prompt a change in the Fed's wording in early 2010. First, the 10-year yield itself is at 4 month highs and the spread between 10-year TIPS and conventional bonds is at the upper end this year's range as is the 5 year/5 year forward. One piece of a multifaceted measure of inflation expectations, the University of Michigan's survey of 5-year inflation forecast, showed some relaxation of expectations in Dec to 2.6% from 3.0% in Nov.

The third paragraph is the policy guidance. It is also unlikely to change substantively. It is likely to maintain that these economic conditions are "likely to warrant exceptionally low levels of federal funds rate for an extended period." It can also be expected maintain the schedule to complete its agency and agency mortgage backed securities purchases at the end of Q1 2010.

Assuming that this overview is generally correct, that there are a few minor tweak in the FOMC statement tomorrow compared with November's statement, there is unlikely to be much of a market reaction. The day before the Nov FOMC meeting concluded, the June 2010 Fed funds futures closed with an implied yield of 42 bp. By the end of that week, the June contract implied a 34.5 bp effective Fed funds rate. Yesterday it closed at an implied yield of 30.5 bp.

The firmer dollar tone that is evident, especially against the European currencies, in the last couple of weeks, seems to be driven more by year-end considerations and position adjusting rather than a shift in expectations about the trajectory of Fed policy.