FOMC Meeting Will Overshadow All Other Events in the Week to Come

Monday, June 27, 2005

Capital markets are in for a thrilling week. The Federal Reserve Open Market Committee (FOMC) will meet on Wednesday and Thursday, publishing its statement on Thursday at 2.15 PM ET. While the consensus focuses on the ninth 25 basis point hike in a row, bringing the Fed Funds rate to 3.25 percent, the release of the final reading of GDP growth in the first quarter could add further ammo for speculation on Wednesday. Analysts are predicting that the growth figure will be revised to 3.7 percent from 3.5 percent in the first quarter. If the revision leads to a better figure for the first quarter, the policymakers at the FOMC will be able to stay on the path of "measured" rate hikes. David Altig's Fed Funds forecast on macroblog meanwhile points solidly to a 25 basis points hike.
All attention will turn towards the wording on the FOMC statement as investors will scrutinize it for hints on the future FOMC policy. Any change in the wording about inflation, which used to be seen "contained" in the last statements, could send markets into a tailspin. The Wall Street Journal had a teaser story, where an analyst said that the markets would also look if the term "accomodative" would still be included. If not it would mean that the Fed thinks inflation has been fought successfully (for the time being.)
A significantly higher GDP reading, say 3.9 percent or more, could lead to heated discussions at the FOMC. There have been enough hawkish tones from several Fed members in the last weeks, warning of inflationary pressures mostly stemming from the record levels of oil prices, now at more than 60 dollars per barrel, and prices for refined products. On the other hand the FOMC will have a hard time to justify a rate hike when the upcoming macroeconomic numbers indicate a slowing growth dynamic. The latest economic indicators have not helped in painting a brighter outlook. House sales slowed and the rise in durable goods orders hinged on aircraft orders which are likely to slow as well when airlines have to shell out ever more money for kerosene.
The fight to contain inflation also bears the risk of slowing the two last support columns of the economy: real estate and consumer spending. At some point higher mortgage rates will translate into less borrowing, a process that has already begun on the consumer credit level as the following graph shows.

Consumer Credit 2000-2005

Real estate lending has leveled off as well.

Morgage Lending 2000-2005

Fed chairman Alan Greenspan repeated to Congress that the Fed is looking forward to stay on its course of a measured removal of policy accomodation on June 9.
Other Fed members were more hawkish. Non-voting Fed Kansas City president Thomas Hoenig concluded earlier this month that the Fed still has some way to go before the "neutral zone", where inflation will be contained and growth not hampered, will be reached. Fed Atlanta president Guynn had said inflation risks all seemed to be pointing in one direction - up - and hinted that more rate increases were coming.
Fed governor Donald Kohn has signalled that he is quite pessimistic for the future and sees no harmless way out of the problems the economy is entangled in, delivering an orange to red alert speech less than two weeks ago.
Looking back to a period where oil prices caused the Fed more or less the same problems as nowadays, that is from 1979 to 1981, then Fed chairman Paul Volcker tackled the period of discomfort with a rapid rise in Fed Funds. Big difference though: He had started raising before oil took off. This time Fed Funds are trailing behind enormously although the economy is in a better shape now than it was then.
Not that Volcker made friends at the White House this way. But when the time for his renomination came, Wall Street mass-mailed Ronald Reagan to stay with the highly respected Fed chairman, keeping him on the Fed chair. This year Volcker has repeatedly asked policymakers to get their act done, as the US is operating on increasingly thin ice, reminding people of the 1970's - a time with a volatile and depressed dollar, inflationary pressures, a sudden increase in interest rates and a couple of big recessions.


GRAPH: Oil prices (blue), Fed Funds (red) and recessions (pink shades)
Alan Greenspan, retiring in 218 days if nothing unforeseen happens, does not have to care about his renomination. He can focus on saving the purchasing power of the dollar.
The question is though how much pressure the Bush administration will exert. As the approval ratings of the president have begun plummeting and the fragile composure of the economy with non-existent job growth in the private sector moves into the focus of voters, Bush will try to avoid higher interest rates at all cost as they will not only slow growth but increase the debt-service portion in the budget.
As there has been no period in history where rates and stocks trended in the same direction, the administration probably sees higher rates also as a kind of flak against its disputed plans for Social Security. The president is already confronted with growing criticism on that issue.
This Week's Economic Data
After last week's leading indicators showing another turn for the worse in nine of the ten subindices, this week's lagging indicators do not offer much hope for a marked upturn of economic conditions. While GDP is expected to come in a notch higher, investors will focus on the ISM Manufacturing Index on Friday which has been on a slide all year long and approaches the contraction zone. Personal incomes are expected to retain their weak growth trend and this could also get reflected in consumer confidence and consumer sentiment readings.
Consumer confidence: consensus 104, last 102.2
GDP Q1 final: consensus 3.7 %, last 3.5 %
Jobless claims: consensus 325,000; last 314,000
Personal income: consensus 0.4 %, last 0.7 %
Consumer spending: consensus 0.1 %, last 0.2 %
NAPM Index: consensus 53.0; last 54.1
Consumer sentiment: consensus 94.5; last 86.9
Construction spending: consensus 0.5 %; last 0.5 %
ISM Manufacturing Index: consensus 51.3; last 51.4
Oil and Gold Remain on the Watchlist
Besides this trickle of data market participants will closely watch the two other inflation indicators gold and oil, which I had correctly predicted to move higher last week. If oil manages to stay above 60 dollars, gold will probably continue its recent gains too after it closed at 440 dollars an ounce on Friday, having decoupled from the dollar since two weeks. As the supply fears will not fade, no matter what the oil stock report on Wednesday tells, the rally might consolidate but not lose much of its steam.
Oil prices at the current levels are designed to leave a painful dent on share markets which sold off significantly the last two trading days for this reason and will have a hard time to shake off the rising oil pressure. As this would indicate higher inflation expectations it could also help to end the conundrum on bond markets, where the 10-year yield closed at 3.91 percent on Friday. The end of the conundrum will come at a price.
Currency markets will likely see a further weakening of the Euro as Europe gets hit hard by the double whammy of higher oil to be paid in a stronger dollar. This in turn will cloud the moderate growth expectations on the old continent even more.
I close with a quote of Donald Kohn's latest speech. "Although the most likely outcome for the overall economy is good, a number of characteristics of the current situation suggest some greater-than-usual risks around that central tendency, and, in particular, raise questions about the pattern of asset price movements that might accompany even favorable overall economic performance."


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