Expectations are swirling about tomorrow’s FOMC meeting and what it will bring in the way of further hints of the timing, nature, and size of the inevitable QE3. But there’s something else to speculate on whenever we have a known important event risk in the crosshairs: what market expectations have already priced in.
There are endless permutations for the possible course of Fed actions in coming month, but there are three main drivers that are feeding into their monetary policy decision making:
1) Soft patch or recession?
First, has the US economy merely hit a soft patch or is it tilting into a full-blown recession? It’s perhaps a bit too early to tell, but it is certainly teetering and the rest of this week’s data will offer further clues – particularly tomorrow’s ISM Manufacturing survey and Friday’s ISM non-manufacturing survey, with the employment picture Friday also playing a role due to the Fed’s dual inflation/employment mandate. Some recent consumption numbers and surveys suggest we’re at stall speed at best at the moment.
2) Elections November 2
Second, there is the election cycle in the US, which should not be underestimated as Congressional and the presidential elections approach on November 2. Bernanke, supposedly a card-carrying Republican, would certainly prefer an Obama presidency as the Democrats are generally in favour of more easing and would throw up fewer rhetorical obstacles to further Fed action than Republicans, who would likely control the presidency and both houses of Congress if Romney wins in November. The Republicans might find momentum heading into the election if the economy is still doing poorly, and they might also use any Fed ‘hyperactivity’ as a wedge issue.
3) Budget ceiling debate
Third and finally, there is the imminent return of the budget ceiling debate as the spending ceiling is approaching far more rapidly than originally anticipated, and the risk of the fiscal cliff on January 1, where huge spending cuts will go automatically go into effect and therefore automatically shrink US GDP if a “lame duck” Congress and possibly even a lame duck president can’t hash out a new deal – a very high risk depending on the election scenario. In that light, the Fed may be looking at this risk and want to save some of its bullets to address it rather than using up its arsenal this early in the game.
My suspicion is that the Fed would like to hold back as long as possible – this despite the article out late last night from the New York Times suggesting that “some Fed officials” are leaning toward pre-emptive action aimed at preventing the risk of recession while we’re still in a grey area of economic weakness/stalling growth. There are two main drivers for my thinking. First, markets are spectacularly complacent already – past punch bowl offerings have come when the market is in a funk rather than rallying strongly, and the irony may be that the market’s own behaviour has delayed the very development upon which the rally is based. Finally, as I state above, I think that Bernanke himself may prefer to avoid the spotlight as much as possible for now and move more forcefully when it is more clear that the US economy remains in funk and/or markets are depressed rather than ebullient and because it would like to keep something in reserve for the potential post-election political gridlock and the risks from the fiscal cliff.
Possible scenarios and market reactions
Remember that until further notice, this FOMC meeting will only see the release of a new policy statement. This is not one of the meetings that includes revisions of Fed economic and policy forecasts nor a Bernanke press conference (which we will see in September.).
Scenario one (most hawkish, somewhat lower odds) The Fed fails to upgrade its potential to act and merely offers further rhetorical twists that suggest it will act if conditions warrant. Market reaction: risk bearish, JPY and USD rally, asset markets and pro-risk currencies sell-off very steeply
Scenario two (baseline): The Fed drops enough hints that if data continues to be weak it will act and may even indicate what the method of QE will be (mortgage + bond buying?). This sets up a September QE3 announcement. The Fed may also make a gesture like extending the time frame of its commitment to keep policy accommodative. Market reaction: somewhat enthusiastic kneejerk reaction in risk appetite across the board, but then consolidation sets in (possibly late this week or not until next week) as much of the easing potential is priced in.
Scenario three (very dovish – low odds): The Fed drops strong hints and suggests it may be looking at new tools (NGDP, etc…?) Market reaction: the risk rally/USD sell-off has more legs than in the baseline scenario – possibly new post-GFC highs in equities in such a scenario.
Keep in mind that the heavy calendar through the end of the week, particularly the ECB meeting on Thursday may make it difficult to isolate the reaction to the FOMC meeting. Much of the recent optimism has been driven as much, if not more, by ECB rather than Fed expectation.
Be careful out there.
John J Hardy,
SAXO BANK