In our preview of the FOMC interest rate decision and statement we highlighted that the Fed was likely to show concern about the economy, but also stick to the scrip in regards to ending its $600 billion quantitative easing program this month. It would however pledge to continue to keep its balance sheet constant by re-investing maturing Treasurys. And that it would keep its “extended period language”.

No surprises there:

From the Statement: “To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent.  The Committee continues to anticipate that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate for an extended period.  The Committee will complete its purchases of $600 billion of longer-term Treasury securities by the end of this month and will maintain its existing policy of reinvesting principal payments from its securities holdings.  The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.”

Here’s how they came to the conclusion with my underlined points for emphasis:

“Information received since the Federal Open Market Committee met in April indicates that the economic recovery is continuing at a moderate pace, though somewhat more slowly than the Committee had expected.  Also, recent labor market indicators have been weaker than anticipated.  The slower pace of the recovery reflects in part factors that are likely to be temporary, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan.  Household spending and business investment in equipment and software continue to expand.  However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed.  Inflation has picked up in recent months, mainly reflecting higher prices for some commodities and imported goods, as well as the recent supply chain disruptions.  However, longer-term inflation expectations have remained stable.”

While the economy’s slow patch is unfortunate, the Fed lays out why its making the case for not doing anything about it.

The unemployment rate remains elevated; however, the Committee expects the pace of recovery to pick up over coming quarters and the unemployment rate to resume its gradual decline toward levels that the Committee judges to be consistent with its dual mandate.  Inflation has moved up recently, but the Committee anticipates that inflation will subside to levels at or below those consistent with the Committee’s dual mandate as the effects of past energy and other commodity price increases dissipate.  However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

So, inflation will ease and growth pick up on their own. Let’s see if this prediction holds true.

In the press conference Bernanke tried to temper any kind of expectations for further quantitative easing making the case that with the threat of deflation mainly averted further easing was now a wrong policy choice. That helped support the USD during his comments.

When asked about the extended period language, Bernanke hinted that the Fed would not take any steps to ease policy for at least two or three meetings as it assesses the incoming data.

Before the meeting, the Fed released its newest growth and inflation projections:

• The FOMC revised down down their growth forecasts for 2011 and 2012. The projected growth for this year’s GDP was lowered to a range of 2.7% to 2.9%, down from the April forecast of 3.1% to 3.3%. GDP outlook for 2012 also was revised significantly lower to 3.7% at the high end of the range from a high of 4.2%.
• Unemployment was revised up to a range of 8.6% to 8.9% this year from 8.4% to 8.7%.
• Headline inflation for 2011 was placed in a range of 2.3% and 2.5%, compared to 2.1% to 2.8% in its April projections, and for 2011 to 1.5% to 2.0% from 1.2% to 2.0%. In both years the lower end of the range has been increased, decreasing the chance of prices stalling out.
• Core PCE too saw an increase, with prices expected to climb 1.5% to 1.8% in 2011, compared to 1.3% to 1.6%.

The higher inflation forecasts seem to have made an important difference to the Fed, which now does not see quantitative easing as a proper solution. We’ll see how long that lasts if the economy continues to disappoint, but it will take several months of persistently worse employment data for the Fed to act with looser policy.

Bernanke also acknowledged that he doesn’t know exactly why the economy has shown these recent weak signs but he gave his best take:

From Marketwatch: “We don’t have a precise read on why this slower pace of growth is persisting,” Bernanke told a press conference after the Federal Open Market Committee meeting where the central bank said it would end a $600 billion bond purchase program as planned in eight days and kept interest rates at historic lows.

Bernanke said that “some part” of the slowdown was due to temporary factor such as higher food and gasoline prices and disruptions to manufacturing because of lack of key parts from earthquake ravaged Japan.

But the Fed chairman said it was possible that some of the slowdown might be to longer-lived issues that could persist into 2012. He cited weakness in the financial sector, the housing market and consumer balance sheets as three headwinds.

“We have an awful lot of uncertainty right now about how much of the slowdown is temporary, how much is permanent; so that would suggest, all else equal, that little bit of time to see what’s gong to happen is — would be useful in making policy decisions,”

Still, today’s performance helped to squash ideas of QE3 at least for now and as a result we have taken one negative factor off the USD. Bernanke performance caused a late sell off in equities, which also helped the USD gain as a safe haven against higher yielders and commodity currencies. The USD also gained on its safe haven rivals not only on the back of the end of QE2 but also on the higher inflation projections.

We’ll see if the end of QE2 switched the fundamental bias for the USD as that has been an anchor around its neck, though the USD continues to have its near zero interest rate to be used as a funding currency for carry trade if investor sentiment and equities prices pick up. In this environment that may be tough and therefore we could see some flows towards the USD.

Nick Nasad
Chief Market Analyst
FXTimes

Information and opinions contained in this report are for educational purposes only and do not constitute an investment advice. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness. FXTimes will not accept liability for any loss of profit or damage which may arise directly, indirectly or consequently from use of or reliance on the trading set-ups or any accompanying chart analysis.

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