Are currency traders as inept at predicting Federal Reserve policy as they seem? Judging from the reaction in the euro dollar to the FOMC statement on Wednesday their forecasting skills are unremarkable. In the 45 minutes after the 2:15 pm status quo rate announcement, the dollar lost almost a figure and a half against the euro. Anticipation of a stronger Fed stance on inflation and perhaps on the dollar seemed to have gotten the market far ahead of where the Fed was likely to go. Was there any realistic expectation that the Fed would have issued a much more supportive dollar pronouncement?
The Fed last lowered rates 25 basis points on April 30th. A rate hike less than three months later would have been unprecedented. It would have destroyed the credibility of the Fed's economic judgment and dealt a severe blow to Mr. Bernanke's desire for transparency and open communication with the market. There was no possibility and no market expectation that the Fed would have raised the Fed Funds rate on Wednesday. And while some many have wished for the hike that Fed Governor Fisher voted for, the chance for it was nil.
Ben Bernanke, the Fed Chairman, began talking about inflation and the dollar barely two weeks ago. With little new information on the US or Eurozone economies coming into the market Mr. Bernanke's several comments were a special focus. But comments to the market and in the media are different than an official Fed tightening bias affirmed in the carefully prepared FOMC statement. If the Fed Governors had come down hard on inflation or the dangers of a weak dollar in their statement, traders would have immediately begun pricing in a Fed rate hike. The stronger the language from the Fed the greater the effect on market pricing; and the stronger the language the sooner the price adjustment.
In the Fed view the economy is fragile. The Fed Governors do not want their options circumscribed by the market at this crucial point. The Governors and Mr. Bernanke may want a few more months for the relatively weak dollar to support the economy through exports before they officially tighten the inflation screws. The Fed could not adopt the official tightening bias now because the future is still quite uncertain. Now is not the time for the Fed to limit its own options.
If traders assumed there was a new Fed policy based on language in the FOMC statement they would have acted on it immediately. And it would not only have been FX traders that jumped but bond, futures, equity and options traders as well. Clearly and quite logically from their own view of the economy, the Fed Governors are not ready to drive rates higher, or to have the markets do so in their place.
In that sense the expectations for a stronger Fed statement on inflation were wildly overstated. This is not a comment on whether the Fed should make a strong statement about inflation and the dollar but only whether the board was likely to do so at Wednesday's meeting.
The statement as written was probably about as focused as the Fed feels is possible right now. A more pointed mention of inflation and the dollar would have excited undue speculation and interest rate movement. If a stronger dollar has benefits for commodity prices, higher interest rates may have negative effects on the economy. In the parlous condition of the US economy that is something the Fed was not willing to risk.
There is ample support for the Fed view that the economy is not collapsing. Considering the economic developments of the past twelve months it is rather astonishing the economy is not in far worse condition. This week the growth in personal income was much higher than expected, largely due to the rebate checks which began to hit consumers' pocketbooks in May. But personal expenditures were also slightly higher than expected. Whatever fears may be harbored amongst economists about the future behavior of US consumers, current consumers are spending and not saving their rebate checks. That of course was the purpose of the rebates, to support the economy with increased consumer spending. Durable goods orders were also better than expected, though no one could ever mistake the flat reading for a positive sign on the economy.
In a difficult week, with fear running through world equity markets, the very moderate fall of the dollar did not necessarily reflect the equity market pessimism. The dollar slipped against the euro because the expectations for the FOMC statement were unrealistic.