Fed Keeps Rates Low for Long

illustration: DNB markets dealingroom

(10.08.2011) In a volatile session stock markets rallied after the Fed promised to keep rates at hold for the next two years.

By Kyrre Aamdal, Senior Economist at DNB Markets

After a positive opening, US stock prices fell further. But after the announcement from Fed, stocks rallied and S&P500 ended up 4.74 per cent. Long-term Treasury yields fell sharply after the meeting, but rose again later. 10y Treasury yield ended down 8 bps from close the previous day at 2.26 per cent.

The USD is down 0.9 per cent versus the Euro. The market turmoil has made Swiss Franc popular and EURCHF has fallen 2.7 per cent from yesterday morning. CHFNOK has increased 3.5 per cent as the NOK weakened versus the Euro. The variations for CHF have been very large.
 
The most important message from the Fed was that the FOMC "...currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013". Previously the FOMC has used the term "...extended period". The two-year Treasury yield fell a few basis points to below 0.25 per cent after the announcement and thus do not price in any rate hike for the next two years. This is also true for the Fed Funds Futures – also before the meeting.

Another important part of the announcement
was that the Fed "...discussed the range of policy tools available to promote a stronger economic recovery" and said that it is "prepared to employ these tools as appropriate". That may have included QE3. This all sounds similar to the comment at the August 2010 meeting that the Fed "will employ its policy tools as necessary". That was eventually followed by Chairman Bernanke flagging up QE2 in a speech at Jackson Hole at the end of August and QE2 being launched in November. A repeat is now a bit more likely and Bernanke's 2011 Jackson Hole speech (due 26th August) has just become even more important. But the big difference from lat year is the inflation picture. Also three out of 10 members voted against the action and several Fed members have earlier questioned the effect of the QE2.
 
Today at 08:00 Statistics Norway releases July inflation figures. We expect core inflation to increase from 0.7 per cent in June to 1.0 per cent in July. This is in line with consensus from both Reuters and Bloomberg. Norges Bank forecasted in June core inflation at 1.3 per cent, but was 0.4 percentage points above for the June inflation.
 
Also today Norges Bank Executive Board meets to decide on the key policy rates. The announcement and the press conference will be due at 12:00 GMT. The key policy rate will most likely be hiked by 25 basis points to 2.50%. This is in line with the monetary policy strategy, which the board is meant to follow provided that the Norwegian economy is not exposed to new major stocks. After the strategy and rate path were announced in June, the interest rates both for NOK and for major trading partners have declined substantially.

The NOK versus trading partners has been 0.3 per cent weaker then assumed for Q3. Key macro figures have been mixed, but June inflation was markedly below expectations. The recent severe financial turmoil, connected to public debt issues in the euro area as well as the US, has certainly heightened the degree of uncertainty regarding the economic outlook. We thus think there is large uncertainty surrounding this meeting, but have a small preference for a rate hike today.