FOREX TRADING

Today’s FOMC statement reflected a cautious view on the economy with an emphasis on modest gains in household and investment spending. “Subdued” inflation remains. Dissent continues.

Economic Outlook: Downgraded Again

Economic activity “has slowed” according to the FOMC statement. We agree. Household spending is increasing gradually but remains constrained by “high unemployment, modest income growth, lower housing wealth, and tight credit.” Real positive momentum in the economy is reflected in business spending on equipment and software. Nonresidential construction spending continues to be weak and housing starts “remain at a depressed level.” We agree.

Our outlook for the second half of 2010 is for growth in the 2 percent range. Growth will be fueled by gains in equipment and software spending, while consumer spending will grow at much slower rate than we have seen in past expansions, likely less than 2 percent. Our outlook is consistent with an economy still struggling with persistent high unemployment. Private sector payroll gains were just 51,000 per month on average over the past three months and now we are seeing cutbacks to state and local hiring. Structural unemployment, represented as a skills/geographical mismatch, remains very apparent and is a long-run problem for the U.S. labor market.

Inflation: Remains “Subdued”

“Substantial resource slack” and “stable” longer-term inflation expectations suggest “inflation is likely to be subdued for some time.” The FOMC’s language has not changed very much on inflation. 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 for the rest of this year.

As for policy, the FOMC maintained the target range for the federal funds rate at 0 to 0.25 percent and conditions are likely to “warrant exceptionally low levels of the federal funds rate for an extended period.”

Dissent: The Limits to Emergency Fed Easing

Kansas City Fed President Hoenig’s dissent (again) suggests that there was some discussion at the FOMC meeting about the retention of the phrase “extended period” when referring to low levels of the federal funds rate. President Hoenig’s view is that the economy is “recovering modestly.” There has long been debate on the market’s expectations for 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. President Hoenig argued that the “extended period” language “limits the Committee’s ability to adjust policy when needed.” If economic growth were to surprise on the upside both the Fed and many investors would be on the wrong side of the interest rate rise, potentially resulting in a rapid and violent market adjustment á la 1994-95.