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.  

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.
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
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. 



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