US Fed: How Should They Address Inflation, the Economic Slowdown, and Financial Insta

[DailyFx]

The Federal Reserve is finally being a bit more realistic about the downside risks to growth, as Dallas Fed President Fisher expects the economy to grind to a halt in the second half of the year. Meanwhile, Chicago Fed President Evans noted that the Fed funds rate was not “adequate” to deal with financial market instability. What does this mean for US monetary policy going forward?



US Fed: How Should They Address Inflation, the Economic Slowdown, and Financial Instability?

The Federal Reserve is finally being a bit more realistic about the downside risks to growth, as Dallas Fed President Fisher expects the economy to grind to a halt in the second half of the year. Meanwhile, Chicago Fed President Evans noted that the Fed funds rate was not “adequate” to deal with financial market instability. What does this mean for US monetary policy going forward? It appears that the FOMC will seek to leave rates unchanged until the end of the year, in the hopes that the economic slowdown will cool price pressures. However, with issues in the credit markets presenting a whole different issue, the Federal Reserve will likely be forced to continue running their various lending facilities (TAF, TSLF, PDCF) in order to maintain liquidity. Indeed, with Fed Chairman Bernanke speaking on financial stability on Friday, we’re likely to hear more on their plans, and the comments could be especially market-moving for US equities, Treasuries, and of course, the US dollar.


Richard Fisher, Federal Reserve Bank of Dallas President

"Worldwide, creditors are tightening their standards and consumers and businesses are correcting their courses...The correction in the housing market has yet to find its bottom. Credit markets remain tempestuous...US consumers are being hammered by declining real income, US savers and investors are being squeezed by negative real interest rates and US companies’ business margins are under pressure."

"I expect US economic growth will decelerate to a snail’s pace, if not completely grind to a halt, in the second half of this year. Indeed, we may see the slowdown extend into 2009 as the excesses that drove the housing markets unwind before the economy can again gear up to cruising speed."

"...until we have a clear sense of what will prevail, monetary policy makers must remain poised to act if slowing growth fails to contain inflationary pressures."



Charles Evans, Federal Reserve Bank of Chicago President

"...since these forecasts were made, I think the risks for growth have increased and the risks for inflation remain elevated and a concern...Indeed, total inflation has exceeded core inflation pretty consistently for over five years, with both measures above 2 percent during much of this time...I view these persistently high rates of overall and core inflation as important concerns for monetary policy."

"...it has become increasingly clear to me that the Fed funds rate alone is neither an adequate or even an entirely appropriate tool for addressing instability in the financial markets. However, the ongoing challenges in financial markets indicate the continued need for substantial liquidity in order to facilitate their functioning and to ensure adequate funding for creditworthy businesses and households."







BOE: Why Their Bark Is Bigger Than Their Bite

Looking at recent hawkish commentary by members of the Bank of England’s Monetary Policy Committee, one would think that the central bank was considering raising interest rates. However, overnight index swaps are actually pricing in over 75bps worth of cuts within the next 12 months. Why? The UK economy is practically on the brink of recession, as the country deals with a housing market collapse rivaling that of the US. Furthermore, unemployment is rising while the manufacturing and services sectors have experienced a contraction in business activity over the past three months. With a dual mandate to maintain price stability and economic growth, it’s fair to say that the BOE will not raise rates, but expect their hawkish rhetoric to continue as they work to keep the public’s perception of inflation expectations contained.


Mervyn King, Bank of England Governor

"There are serious upside risks around that central projection, which stem from the possible impact of continuing high inflation in the near term on pay growth and on inflation expectations."

"It is bound to be the case there will be a quarter or two of negative growth."


Timothy Besley, Bank of England Monetary Policy Committee Member

"This spiral has to be nipped in the bud and that means having interest rates at a suitable level until the threat of higher inflation has passed...All being well, inflation will fall again next year and will be much closer to the two percent target by the end of 2009. But that will only happen if people don't chase inflationary wage increases."

"Some have looked to the MPC to cut its interest rate to help...But our job is to fight inflation because that's the best basis for the economy to grow, create jobs and allow living standards to rise."






Compiled by Terri Belkas, Currency Strategist for DailyFX.com

Questions? Comments? E-mail: tbelkas@dailyfx.com