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No Fed Action – Where it Leaves Us

Paresh Upadhyaya
calender-icon Posted on August 02, 2012


The Federal Reserve left the Fed funds target rate unchanged at 0.25%, in line with expectations. Contrary to expectations, the Fed kept its forward guidance unchanged by retaining the “keeping exceptionally low rates at least through late 2014” language. The Fed did not deliver a bond-buying “QE3”quantitative easing action as many had hoped it would. However, it clearly left the door open to QE3 with a strongly worded statement that it will “closely monitor incoming information on economic and financial developments and provide additional accommodation as needed.”

The Fed downgraded the economic outlook from its June statement in which it noted the economy “has been expanding moderately this year,” to saying “economic activity decelerated somewhat over the first half of the year” in yesterday’s statement.  So it’s a wait and see situation.

Behind Wait and See

Some investors will question why there was no fed action. As regular readers may recall from our last blog on the Fed, we were more skeptical on the likelihood of QE3 than the markets. We highlighted 3 factors:

  1. While economic activity is slowing, it may not be weak enough to justify further stimulus, especially in an environment where the Fed has finite choices. This was supported with another key economic release, Construction Spending, which showed Q2 GDP growing at 1.7%,  not too far from trend.
  2. The Fed’s measure of inflation expectations remains largely unchanged from the last FOMC meeting   again not pointing to deflation.
  3. The Fed continues to put strong emphasis on the lackluster recovery in the labor market. The Fed may be waiting for the August and September nonfarm payroll numbers to determine if the labor market is weak enough to ease policy.

Where does this leave us? Continuing to pore over the high frequency economic data searching for further signs of weakness, I’m afraid.

Implications to the Market

As the market digests the news that there was no immediate monetary policy action, there is bound to be disappointment. Given high frequency U.S. macroeconomic data coming in weaker than expected in the second quarter, and a number of Fed Governors opening the door to some form of unconventional monetary action, market expectations for Fed action were quite high. In fact, these expectations reached a crescendo following a July 25 article in The Wall Street Journal titled, “Fed Moves Closer to Action.” (WSJ.com in the Economy section).

In the short term, there is risk of a negative knee-jerk reaction in asset prices. The equity markets remain most vulnerable. However, we would argue the downside may be limited with the prospect of QE3, should economic conditions weaken further. Similar to the potential equity market reaction, bond yields are likely to rise but are pegged for the longer term as the Fed is likely to keep rates low for an extended period of time.

The U.S. dollar is likely to retrace some of its recent weakness as market expectations were high for QE3. However, as we head toward the next meeting of the FOMC, the dollar is likely to come under some pressure as expectations rise for some form of unconventional monetary policy. Nonetheless, it is our expectation that any short-term dollar pressure will be just that. A third round of QE will likely exhibit a smaller marginal impact due in part to diminishing returns from further rounds of easing. In addition, global growth concerns, the level of risk appetite among investors and European peripheral woes are likely to be more important drivers of the dollar.

 

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