FOREX TRADING

Fed Upgrades Economic Outlook, A Dissent on “Extended”

Today’s FOMC statement was more optimistic on the economy with emphasis on improvement in business and investment spending. “Subdued” inflation remains. Dissent brings into question the length of easy policy.

Economic Outlook: Upgraded

Economic activity “continued to strengthen” according to the FOMC statement. We would agree. Household spending continues to expand but with the drag of income, wealth and credit constraints. The story here though is the upgraded outlook for business spending in equipment & software. Again we agree, orders and shipments reports have improved in recent months and that is consistent with increased capital spending.

Our outlook for 2010 is for 2.7 percent growth compared to the recession of last year with equipment & software spending up 4-5 percent compared to a drop of more than 15 percent last year. Two interesting aspects appear in this recovery from these trends. First, gains in the economy are associated with no additional labor so far. As a result, we are seeing very strong productivity gains. Second, adding capital equipment without labor suggests a rise in the capital/labor ratio. These two trends suggest increased returns to a smaller workforce but more limited job opportunities to those without the right skills.

Inflation: Remains “Subdued”

“Substantial resource slack” and “stable” longer-term inflation expectations suggest “inflation is likely to be subdued for some time.” Certainly resource slack, if measured by unemployment or capacity utilization, remains substantial. For the near term we do expect the core PCE deflator to remain subdued at less than 1.5 percent or so.

However, we have noticed that inflation expectations have started to rise when gauged by the five-year/five year forward rates. The rise is still very modest but enough to move the ten-year Treasury yield upward over the rest of this year. Therefore, the yield curve is expected to steepen as the Fed keeps short rates low and long rates drift upward as the flight to safety trade goes away and inflation measures also edge higher.

Dissent: The Limits to Emergency Fed Easing

Kansas City District President Hoenig’s dissent suggests that at the FOMC meeting there was some discussion about the retention of the phrase “extended period” when referring to low levels of the federal funds rate. Historically, there has been a long debate on the market’s expectations of interest rates and expectations for Fed policy that are themselves influenced by Fed comments. By stating “extended period” the Fed may induce economic agents to play the yield curve or the carry trade fairly aggressively and this alters economic activity. During the earlier part of this decade low rates induced adjustable rate mortgages that later came back to hit borrowers with jumps in payments. Also, an extended period of easy policy could allow the build-up of inflation pressures that would become difficult to control. Letting the inflation genie out of the bottle is a risk.

Wachovia Corporation
http://www.wachovia.com

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