Marking Time Ahead of the Fed

The US dollar is trading quietly, largely within yesterday's ranges ahead of the much anticipated FOMC meeting. Even more broadly, the capital markets are relatively quiet. Asia-Pacific equities were mostly lower, except for Japan, Thailand and Australia. Of note, Chinese shares edged lower to new six month lows amid the rising money market rates and talk that officials may begin granting approvals for new initial public offerings. European shares are narrowly mixed and the Dow Jones Stoxx 600 is off marginally, but of note the financials are the weakest sector.

There are three parts to the Fed story today: the FOMC statement, the forecasts and Bernanke's press conference. The statement itself is likely to be the least important. The general assessment of the economy is unlikely to change significantly. The description of price pressures and the labor market may be tweaked to recognize the lower core inflation and continued modest improvement in labor market conditions.

The Fed's forecasts are important. They are part of the forward guidance and is the bar against which the actual economic data needs to be measured against for policy implications. Here the Fed is likely to revise down its growth forecasts and, probably, its inflation forecasts. The mid-point in the March forecasts for GDP was 2.6%. This is well above market expectations which are closer to 2% for this year. The Fed may also shave next year's forecast from the current 3.2%. The 2015 projection of 3.3% (mid-point)may not be changed and is actually closer to market forecasts. Note that the US economy has not grown by more than 3% for a full calendar year in 8 years.

In March , the Fed's inflation forecast (mid-point) was 1.6%. The latest reading puts the core PCE deflator at 1.1%. Many Fed officials have argued the decline in price pressures is temporary. It may be, but it does not mean that it will decline further first. The Bloomberg consensus for the core PCE deflator this year is 1.5%. The Fed's unemployment forecast was 7.4% (mid-point) in March. The actual rate was 7.6% in May. While it could be tweaked, there seems to be a growing sense that the participation rate, the key to the decline in the unemployment rate, is likely to stabilize rather than recover.

The third part of the Fed's story today will be Bernanke's press conference. In his prepared remarks, we expect the Chairman to help investors differentiate between tapering and tightening and to try to drive home the point that current conditions are not sufficient to slow down the long-term asset purchases ($85 bln a month). The data, while encouraging, is still not good enough. The adjustment in the capital markets in general and risk assets in particular,have eased the risk that QE is fueling bubbles. And the subdued price pressures give the Fed more leeway to allow its experiment to continue. The Fed exited QE1 and QE2 too early and needs to avoid making the same mistake for a third time. 

There were two other developments to note.  First, Japan reported a large, but smaller than expected trade deficit for May.  On an unadjusted basis the trade deficit was JPY993.9 bln compared with a consensus forecast of JPY1.22 trillion.  On a seasonally adjusted basis, the JPY821. bln deficit compares with JPY890 bln consensus forecast and a downwardly revised JPY702.8 bln in April.  

Perhaps more importantly exports were stronger than expected.  Contrary to claims by some Japanese and foreign observers, the fact of the matter is that Japan's exports as a percent of GDP are more in line with the US (mid-teens) than Germany, Switzerland, Finland, Sweden and China (40-50%).  Japan's exports rose 10.1% from a year ago.  The market had been expecting about a 6.5% increase after 3.8% in April.  Imports rose 10%, not the 11% the consensus was expecting. 

Second, the minutes from the Bank of England's MPC meeting earlier this month were released.  At his last meeting, Governor King was again out-voted (6-3) against renewing gilt purchases.  Carney takes over the reins beginning next month.  It is possible that he too is out-voted at his first MPC meeting.  The majority of the MPC seems content with its current stance in that the recent data points to a cyclical recovery, while there is still risk of higher inflation in the coming months.