The FOMC will certainly raise its federal funds rate target by 25 basis points
next week. A 50 basis point hike can be essentially ruled out as it would be
inconsistent with the FOMC's commitment at the May meeting to be "measured"
in terms of the pace of monetary policy tightening. This means that the focus
should instead be on the balance of the risks assessment and the language used
in the statement. In our view, the balance of the risks statement will be left
symmetric. The economic data has not broken strongly enough one way or the other
to warrant a change and a shift towards asymmetry towards either stronger growth
or higher inflation would jolt financial markets.
In terms of language, this is a more tricky question. Clearly Fed officials
want a bit more flexibility to be able to respond more aggressively should the
data warrant it. At the same time, the FOMC undoubtedly does not want market
participants to jump to the conclusion that the next move in August will be
50 basis points. That suggests two alternatives: (1) "Measured" left
in but even more heavily qualified and conditioned on the incoming data, or
(2) the substitution of a synonym that is a bit softer and provides Fed officials
with more flexibility.
The FOMC presumably will want to keep the impression that the most likely path
is a series of 25 basis point tightenings, while at the same time gaining a
bit more flexibility to be able to deviate from this should the data warrant.
It is a foregone conclusion that Fed officials will begin the tightening process
next week at the June 29-30 Federal Open Market Committee meeting with a 25
basis point rate hike. A fifty basis point hike is extremely unlikely because
Fed officials have already made a precommitment that the tightening process
will be "measured". Even if Fed officials no longer prefer a "measured"
course, they would stick to that course at the June 29-30 meeting because to
contradict that would risk undermining the credibility of the FOMC's future
statements and precommitments. Although the key sentence in the statement is
qualified with the phrases "At this juncture" and "likely",
this does not provide sufficient room for a 50 basis points hike. A 25 basis
point hike will also be the outcome for three other reasons:
1. In the initial stage of the tightening process, Chairman Greenspan
clearly has favored a gradual start. In February 1994, for example,
despite considerable sentiment among other Fed officials that the FOMC begin
with a 50 basis point move, Chairman Greenspan held out for a smaller 25 basis
point rate hike.
2. Fed officials are fundamentally less anxious about the inflation
outlook than many financial market participants.
Rather than judging themselves far "behind the curve", most Fed officials
are very happy with how the economy has evolved. A year ago, Fed officials were
worried about deflation and the absence of job growth. Now the economy is on
firmer footing and inflation has drifted up a bit. This is what Fed officials
were hoping for.
3. A 25 basis point hike is what market participants expect.
As of Wednesday morning, the July federal funds futures contract was trading
at 98.7350, or a yield of 1.2650%. To do more than 25 basis points would jolt
financial markets. The FOMC generally likes to make few waves when it tightens
monetary policy. Instead, the issues at the June meeting will be whether to
change the balance of the risks assessment on growth and inflation- both currently
at neutral-and how to adjust the language of the statement to give the FOMC
greater flexibility to move faster or slower, depending on the tenor of the
economic data. Also, the FOMC will be revising its "central tendency"
forecast projections for 2004 and compiling the initial projections for 2005.
However, these projections will not be made available until the Chairman's semi-annual
monetary policy testimony to Congress expected sometime in mid-to-late July.
On the balance of the risks assessment, we expect the FOMC to stand pat. The
growth pace of real GDP seems stable at around 4% to 4.5% and the year-over-year
core CPI rose at a slightly more modest 1.7% annual rate in May, compared to
1.8% in April. Also, a shift in the balance of the risks assessment would contradict
the tone of recent Fed speeches and testimony that imply that Fed officials
are generally comfortable with developments in the economic environment.