Wednesday, October 8, 2014

The FOMC takes dollar strength into account; liftoff expectations shift to a year from now

The Fed is finally expressing unease with the world outside the US borders and its impact on the US economy.
FOMC Sep-14 Minutes: - "During participants’ discussion of prospects for economic activity abroad, they commented on a number of uncertainties and risks attending the outlook. Over the intermeeting period, the foreign exchange value of the dollar had appreciated, particularly against the euro, the yen, and the pound sterling. Some participants ex-pressed concern that the persistent shortfall of economic growth and inflation in the euro area could lead to a further appreciation of the dollar and have adverse effects on the U.S. external sector. Several participants added that slower economic growth in China or Japan or unanticipated events in the Middle East or Ukraine might pose a similar risk. At the same time, a couple of participants pointed out that the appreciation of the dollar might also tend to slow the gradual increase in inflation toward the FOMC’s 2 percent goal."
In a single paragraph the FOMC minutes conveyed the concerns about the rising US dollar and risks of further dollar appreciation due to economic weakness across major economies. Strong dollar hurts US exporters and reduces dollar denominated revenues for firms that conduct a great deal of business abroad. It also puts downward pressure on inflation (see post), elevating disinflationary risks. This is clearly visible in TIPS-based inflation expectations (breakevens) that continue to decline.

The FOMC's projections for US GDP growth a couple of years out have shifted lower in part because of slower economic expansion around the world.

Source: FRB

The markets interpreted the minutes as a clear signal that the Fed is in no hurry to normalize rates. Even though the US foreign exchange policy is under the control of the US Treasury (instead of the Fed), the FOMC would clearly like to avoid a significant dollar appreciation and will remain on hold should the rally continue. With events in the rest of the world now becoming a greater part of the FOMC's playbook, the expectations for liftoff have shifted further out in time. The chart below shows the July-2015 Fed Funds futures spiking after the release of the minutes (reducing Fed Funds rate expectations for next summer). The markets are now pricing in the first hike taking place about a year from now.

Source: CME

Equities, treasuries, many commodities, credit - all rallied in response. The FOMC is telling us that with the rest of the world in relatively poor shape economically, the stimulus party in the US continues for a while longer.

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