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
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
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
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 simply unrealistic.
FX Solutions, LLC
Chief Market Analyst