Fed to Stand Pat, but Statement may be More Constructive

The Federal Reserve's two-day meeting concludes tomorrow. There is little doubt that it will stand pat. There is not press conference afterward, so the statement is the only thing investors will get.

The statement is important. We argue that the FOMC statement is the clearest expression of the views of the Fed's leadership. The minutes are more comprehensive they dilute the signal from the Fed's leadership, and it conflates the difference between voters and non-voters and between the Governors and regional Presidents.

The Federal Reserve was designed to concentrate power with the Governors. The passions of the local business would be checked by the Washington-based Governors. The regional presidents rotate voting. The NY Fed has a permanent vote on the FOMC. Four other regional presidents get to vote on the FOMC. The power struggle between the Republican Senate and the Democratic President has altered the balance of power at the Federal Reserve. There are two vacancies on the Board of Governors. This gives the regional presidents five votes, including the NY vote and there are five Governors.

The Fed's leadership is important because it is where policy emanates. Yellen, Fischer, and Dudley are more frequently on message, though admittedly sometimes, like at her semi-annual testimony before Congress, Yellen represents the Fed as a whole and not just her views. The regional Presidents express their views; it seems, more than the institution's views.

In tomorrow's statement, the FOMC's leadership will recognize that the economy appears to have gathered momentum as Q2 drew to a close. Nearly every significant economic report has come in better than expected. Data surprise models are in overdrive. The weakness of the May employment report cast a pall over the June FOMC meeting, and the pending UK referendum did not help matters.

The FOMC statement is likely to be more upbeat. The nervous Nellies have liked been reassured by both the improvement in the labor market, renewed consumption and the general resilience of the capital markets in light of the UK's referendum. Moreover, the markets seem unperturbed by the weakness of the Chinese yuan and China's equity market losses. Last August, and as recently as January, China's markets were a cause of much consternation among investors.

While full employment is being approached, there has not been as much progress on price stability. However, officials may find comfort in the fact that the 10-year breakeven is essentially unchanged at 1.50% since the June FOMC meeting despite the decline in absolute yields. The statement will likely note that although market measures of inflation expectations remain low, the survey measures are stable.

The Federal Reserve's broad trade-weighted measure of the dollar rose every month in H2 15 and through January 2016. It fell by nearly 5% in the three-month slide (February-April). It edged higher in May-June (1.3%). This Fed measure is updated monthly, but the Bank of England's trade-weighted index is updated daily, and as one would expect, it is highly correlated with the Fed's measures. The BOE's trade-weighted measures of the dollar were up five week's through July 22. Over this run, it has risen by almost 3%. We suspect this pace of appreciation is not particularly worrisome, and some Fed officials will see it as at least partly a result of the anticipated divergence of monetary policy.

Without making a commitment to raising rates in September, what can the Fed do to drive the point home that it is a live meeting? We suspect that the Federal Reserve can re-introduce a risk assessment that is had dropped earlier this year. This would indicate a normalization of its communication and reflect greater visibility, as well as confidence.

Investors are more comfortable with a December hike rather than a September move, and the November meeting is too close to the election to be live. The effective Fed funds rate has risen by around three bp over the past month to 40 bp. If the effective Fed funds rate remains at 40 bp until the FOMC meets in December and the Fed hikes then, fair value for the December Fed funds contract is near 53 bp. The contract implies 49 bp. That is to say, nine bp (49-40) of a possible 13 bp move (53-40) or nearly 70% chance of a December hike has been discounted.

Lastly, a word about dissents. KC Fed President George has already indicated she favors an immediate hike, after pulling her dissent in June. Investors would regard the statement as more hawkish if George were not alone. We note that three voting members of the FOMC recently voted for a discount rate hike: Bullard, Mester, and Rosengren. If there is more than a single dissent, these would seem as likely candidates.