[ForexNews]

The 12 August FOMC statement went one step further than the previous statement, commenting that economic activity is “levelling out”. But the Fed was cautious, noting that household spending is constrained by a long list of factors including “ongoing job losses, sluggish income growth, lower housing wealth and tight credit”. It is significant that “sluggish income growth” was a new item in this list compared to the June Statement. Sensibly, the FOMC is hesitant to call the turning point for the economy. Persistent economic strength will be required before any alteration from the current stance on rates can be expected. Crucially the Statement retained the line that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period”.

The Fed also left its sound-bite on inflation exactly the same as the June statement, expecting that “inflation will remain subdued for some time”. The June FOMC Statement dropped the reference to the risk that inflation could be too low. This was probably premature and it may come back into the Statement next year. The risks still lie with deflation not inflation. With inflation declining over the next year the FOMC will have the luxury of waiting to observing the strength of the recovery before raising rates.

On Quantitative Easing (QE) the Fed did not announce a curtailment of the programme or an expansion. But it did announce that “to promote a smooth transition in markets as these purchases of Treasury securities are completed” it would “gradually slow the pace of transactions”. The implication is that the Fed does not expect any further purchase of Treasuries beyond October but the Statement does not rule out more purchases if necessary.

[ForexNews]

The shortest gap between the official trough of the economy and the first Fed rate hike was six months, in 1983. But this quick response reflected the strong anti-inflation stance of the Volcker Fed, still trying to squeeze inflation out of the system. In the two recent recovery phases, after 1991 and after 2001 the Fed waited 35 months and 19 months respectively before the first rate hike. Historically the Fed always has waited for unemployment to come down before beginning a tightening cycle. In the two earlier recessions this happened quickly, but in the two recent recessions, the so-called jobless recoveries, it took much longer. Typically, capacity use has also moved up significantly before the Fed begins to hike - again 1983 was the exception in that capacity use had only moved up a little and was still low at 73.7. Traditionally, the Fed regards 80% or more as approaching full capacity. ISM manufacturing has also always moved up considerably before the first hike, at least to the 56 level, which is consistent with GDP growth of 2-3% pa. In 2004 the Fed waited until the ISM reached 60, a level consistent with growth of above 3%.

[ForexNews]

A few weeks back Bernanke discussed the exit strategy in his Wall Street Journal article and in testimony to Congress, emphasising that the process of reversing QE is not difficult but the issue is timing. The Fed may use a partial reversal of QE as a first step to tightening before it begins to raise rates, but that it will certainly not attempt to bring the Fed's balance sheet all the way back to normal before hiking. The Fed's balance sheet will likely contract anyway over the next twelve months as some of the special liquidity programmes wind down. Beyond that the Fed may begin to sell short term maturity debt into the market to mop up excess reserves. Depending on the strength of the economy this could begin during the second half of 2010. But it will likely continue hand-in-hand with rate hikes during 2011.

[EmmaKarol]

[Stefaniayog]