Tuesday, December 12, 2006

There is a chance in 2007 that the fed will ease monetary policy approximately 100 bps in 2007!

FOMC Meeting
Bottom line: As expected, the Federal Open Market Committee (FOMC) left the funds rate at 5.25% at today's meeting. Nor were there any major changes to the statement. The statement continues to say: “some inflation risks remain,” indicating that the FOMC is still committed to a tightening bias with risks skewed toward inflation. We still expect the next move will be an easing, although not until March 2007.

Two edits were made to the economic growth paragraph: (1) Fed officials now characterize the weakening in the housing market as a “substantial” cooling. Previously, Fed officials described the weakening as just a cooling (and until September just a “gradual” cooling). (2) Fed officials communicated more uncertainty on the growth outlook going forward. At the previous meeting, they said “the economy seems likely to expand at a moderate pace.” Now they implicitly tone down their confidence in that outlook by prefacing the earlier sentence with: “Although recent indicators have been mixed.” In other words, not all major indicators are now viewed as consistent with expansion at a moderate pace. Also, they added “on balance” after “expand at a moderate pace”. “On balance” is a qualifier often used to communicate “more often than not” but not “consistently.”

We continue to forecast 100 bp of easing in 2007, in response to continued sub-par growth (around 2% for the next few quarters), a modest uptrend in unemployment, and further fading of inflation fears.

Today’s statement, along with the “edits” to the October 24-25 statement, is shown below. Once again, Richmond Fed President Lacker dissented—he wanted another 25 bp hike; the dissent could be read as hawkish, since other officials may also have wanted a hike but may not have been voters or may have preferred not to undermine the chairman’s leadership. However, the minutes to the last two meetings did not suggest much support for Mr. Lacker.

2007 U.S. Monetary Policy: What & Why
What We Expect
  • We project that the Fed’s Federal Open Market Committee (FOMC) will start to lower the current 5 ¼% federal funds rate at its March 20-21, 2007 FOMC meeting. By yearend of 2007 we expect the fed funds rate to be 4 ¼%.


  • The Fed is projected to enact 25 basis point Fed funds rate reductions at the 2007 FOMC meetings on March 20/21, May 9, June 27-28 and August 7.

Why Ease?

  • Part of the Fed’s dual mandate is for the economy to realize its underlying growth potential. In the current setting, continued real economic expansion below the growth of the economy’s potential output should start to be evidenced in a higher unemployment rate, which we expect to average 4.7% in Q1(07) and eventually reach 5.1% before the end of 2007. The main reason for below potential growth is the transition from a housing boom, which added roughly 1.0 percentage point to annual real growth, to a slump, which should trim between 1 and 1 ½ points from annualized real growth through mid-2007.
  • The Fed also is mandated to control inflation, with current Fed leadership citing a 1% to 2% “comfort zone” for the “core” (nonfood, nonenergy) annual inflation of the Personal Consumption Expenditures (PCE) chain price index. We believe that recent such inflation somewhat over 2% was not broad-based and will subside, with a typical lag, following lesser demand pressures versus supply.


  • The January 30-31, 2007 post-FOMC meeting statement should no longer cite risks as being skewed toward inflation.
  • The monthly unemployment rate should be edging higher as annualized rises in the monthly “core” PCE chain price index subside.

  • The major risk to forecast 2007 Fed easing is that wage inflation is unexpectedly stubborn despite a somewhat higher unemployment rate accompanying sustained slow growth.

When is there enough easing?
  • After four consecutive 25 basis points Feds funds rate cuts, we expect the Fed to be on hold again at the final three FOMC meetings in 2007 as the real estate slump’s negative growth drag finally wanes.

Positions on Key Fed Issues
  • Potential real growth in 2007 is estimated to be around 3%.
  • Inflation targeting is not expected to be formally adopted in 2007, with Fed officials instead reiterating a 1% to 2% “comfort zone” for core PCE price inflation.
  • Fed Chair Bernanke during 2007 is expected to be somewhat more sensitive to growth versus inflation risks.
  • Fed to remain more responsive than proactive vis-à-vis addressing potential asset price “bubbles” before they deflate.
  • A lower dollar should not much affect the Fed’s inflation expectations considering low recent pass-throughs from lower dollar to higher import price.

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