Need To Know News

The Federal Open Market Committee kept its target for the Federal Funds rate at 2%.

While the FOMC continues to see economic activity as expanding on exports and consumer spending, inflation was characterized as high, spurred by earlier increases in the prices of energy and some other commodities.

“Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee. The Committee will continue to monitor economic and financial develpments and will act as needed to promote sustainable economic growth and price stability.”

Mr. Fisher was the lone dissenter.

Interest rate futures markets indicate a foregone conclusion to this afternoon’s rate announcement, as the Fed is widely expected to leave the Fed funds rate unchanged at 2%. Recent Fed speak has hinted at forthcoming rate increases, despite the prevalence of downside risks; however, the continued struggles in the credit market and deteriorating market confidence should leave the Fed’s hands tied.

Front month Fed fund futures are nearly unchanged on the day and currently show a 93% chance the Fed will leave rates unchanged this afternoon. Fed fund options fall directly in line with front month futures, also indicating a 93% chance the Fed funds rate will be left at 2%.

Binary options show a 95% chance the Fed will leave rates unchanged this afternoon, along with a 3.8% chance of a 25bps hike and a 1.1% chance of a 50bps hike.

Fed funds futures, including Fed Fund options and binary options, continue to show a resounding bias favoring an unchanged Fed funds rate after tomorrow’s FOMC rate announcement.

Fed fund futures are slightly higher on the day in response to higher-than-expected June PCE data this morning, but still show a 92% chance the Fed funds rate will be left at 2% tomorrow. Further-dated Fed fund futures are slightly lower and now show a 28% chance of rate hike in September (from 30% on Friday).

Front-month binary options show a 95% chance the Fed will leave rates unchanged tomorrow, with 3.4% betting on a 25bp hike and 1.3% betting on a 50bp hike. Further-dated binary options show only a 52.6% chance the Fed will leave its rate unchanged in September, with an 18.6% chance of a 25bp hike, a 10.3% chance of a 50bp hike, and an 8.1% chance of a 25bp rate cut in September.

The FOMC has been warning about downside risks to growth for months now.  More recently they’ve added the upside risk to inflation.  Monetary Policy cannot address both of these problems at the same time because the conventional cure for each is in the opposite direction.  The FED, in trying to manage the credit crisis, has perhaps made their decision making process more difficult as their focal point of view has widened.  Of late, FED speakers often throw fiscal policy initiatives into the mix, pressing for more control over fiscal policy in an effort to effectively apply monetary policy.  Tomorrow’s FOMC minutes should be interesting in that the downside risks to growth stem primarily from an out of control banking system and the pressure it is exerting on the entire economy.  The FED’s policy response to the collapse of the housing sector, in hindsight, was easier credit.  Easier credit has likely exacerbated inflation though the FED talks primarily about food and energy prices, not consumer credit.    There is virtually no chance of a rate change tomorrow with the twin problems of inflation and tanking growth.  Indeed, the FED is without a policy tool having used up rate cuts to address the housing sector/bank crisis only to find that looser policy could not address the morass the banks made.  It could be argued that all those eases from the FED made leverage less expensive, helping to drive up commodities prices.  Yup, it’s a mess.

Tomorrow’s FOMC announcement is likely to  keep rates unchanged but to contain strong inflation warnings.    After today’s inflation data, including the highest year on year reading since 1991 in the PCE Price Index, expect the FED to mention inflation expectations and their moored or unmoored status.  Food and Energy Prices are bound to be discussed and there may be a nod to Plosser’s contention that the FED needs to pay more attention to headline inflation in it’s policy response.  More on the FOMC throughout the day.

Fed funds futures are slightly higher, but off their best levels after the employment numbers. The market continues to show no action on rates from the FOMC over the near term given the renewed instability in the financial markets and the subpar economic data. Indeed, most Fedwatchers doubt there will be any action from the FOMC ahead of the November elections. The Aug implied rate is trading at 2.04%. The Nov implied rate is at 2.15%, suggesting about a 60% chance for a 25 bp tightening by the end of November. Jan is trading at 2.22%. The market had a much more bearish tint two months ago, before the GSE crisis, and the market had priced in 75 bps in tightening by year end.

Speaking in Philadelphia this morning, Philly FED president Charles Plosser says:

* The current “very accommodative” Fed policy will need to be reversed, “sooner than later”

* Tame Core inflation will not keep inflation expectations in check

* FED will have to back up words with action

*Monetary Policy should take headline inflation into account, as the public’s expectations influenced by persistently high headline inflation numbers

* Real fed funds rate -1% to -2%

* 2008: slow economic pace, 4% headline inflation

* 2008 unemployment is likely to get worse before it gets better

* Expect to see 2009 growth nearer to long-term trend

The minutes of the June 24-25 FOMC meeting provided little new information beyond what has already been presented during Chairman Bernake’s testimony before Congress.

The current economic outlook was presented in a generally negative light with manufacturing deteriorating, business investment weakening and residential construction in continued deep descent. Labor markets had weakened in April and May. Despite the gloomy numbers, “FOMC participants noted that spending in recent months had evidently been less weak than anticipated.” The forecast of growth prepared for the meeting had been revised up slightly indicating that “economic activity in the first half of the year had been somewhat firmer than previously expected.” However, the staff projection pointed toward a slowdown in growth during the second half of the year, a somewhat different view than had previously been presented. That slowdown is based on several factors restraining spending including lower wealth, slower real income growth and tight credit conditions.

Participants continued to see significant downside risks to growth despite the slightly better than expected performance in the first half.

Inflation continued to be of concern with headline inflation numbers driven higher by food and energy costs. “Although readings on core inflation had improved somewhat, energy and other commodity prices had increased, and some indicators of inflation expectations had risen in recent months.” Some of the recent improvements in core inflation readings were “seen reflecting transitory factors, and the forecast of core inflation for the second half of this year and next year was marked up to incorporate the likely pass-through of the recent jumps in the prices of energy and other commodities.”

Credit markets continued weak and the deteriorating condition of some financial guarantors and mortgage insurers contributed to worries about banks. However, there is no mention specfically of the recent concerns related to Fannie Mae and Freddie Mac.

Some participants noted that the real fed funds rate was negative by some measures and thus was providing considerable support to aggregate demand. If the negative real fed funds rate was maintained it could lead to higher trend inflation. However, the frail financial markets indicated to some participants that the markets were not particularly accomodative and the report notes generally tight credit conditions interbank and for small business from regional banks.

Overall the report is frankly downbeat despite better than expected H1 performance.

Fisher dissented based the likelihood of higher inflation.

Duke’s nomination, along with that of Larry Klane and the re-nomination of Randall Kroszner, had been held up in the Senate Banking Committee for over a year.