The Federal Reserve's two-day meeting concludes on Wednesday and there's little doubt it will stand pat. There is no press conference afterward, so the statement is the only thing investors will get.
And that statement is important. We argue that the FOMC statement is the clearest expression of the views of the Fed's leadership. The minutes are more comprehensive as they dilute the signal from the Fed's leadership, conflating the difference between voters and non-voters and between governors and regional presidents.
The Federal Reserve was designed to concentrate power among its Governors. The passions of the local business would be checked by the Washington based governors. The regional presidents rotate voting. The NY Fed has a permanent vote on the FOMC. Four other regional presidents get to vote on the FOMC. The power struggle between the Republican Senate and the Democratic President has altered the balance of power at the Federal Reserve, where there are two vacancies on the Board of Governors, giving the regional presidents five votes -- including the NY vote. All told, there are five governors.
The Fed's leadership is important because it is where policy emanates. Yellen, Fischer and Dudley are more frequently on message though sometimes, like at her semi-annual testimony before Congress, Yellen represents the Fed as a whole and not just her views. The regional presidents, it seems, express their views more than the institution's views.
In Wednesday's statement, the FOMC's leadership will recognize that the economy appears to have gathered momentum as Q2 drew to a close. Nearly every significant economic report has come in better than expected. Data surprise models are in overdrive. The weakness of the May employment report cast a pall over the June FOMC meeting, as the then pending UK referendum did not help matters.
The FOMC statement is likely to be more upbeat. The nervous members have likely been reassured by the improvement in the labor market, renewed consumption and the general resilience of the capital markets in light of the UK's referendum. Moreover, the markets seem unperturbed by the weak Chinese yuan and China's equity-market losses. Last August, and as recently as January, China's markets were a cause of much consternation among investors.
While full employment is near, there has not been as much progress on price stability. However, officials may find comfort in the fact that the 10-year breakeven is essentially unchanged at 1.50% since the June FOMC meeting -- despite the decline in absolute yields. The statement will likely note that although market measures of inflation expectations remain low, the survey measures are stable.
The Federal Reserve's broad trade-weighted measure of the dollar rose every month in H2 15 and through January 2016. It fell by nearly 5% in the three-month slide (February-April). It edged higher in May-June (1.3%). The dollar measure is updated monthly, but the Bank of England's trade-weighted index is updated daily, and as one would expect, it is highly correlated with the Fed's measures. The BOE's trade-weighted measures of the dollar were up five week's through July 22. During that time, it rose by almost 3%. We suspect this pace of appreciation is not particularly worrisome, and some Fed officials will see it as at least partly a result of the anticipated divergence of monetary policy.
Without making a commitment to raising rates in September, what can the Fed do to drive the point home that it is a live meeting? We suspect that the Federal Reserve can re-introduce a risk assessment that it dropped earlier this year. This would indicate a normalization of its communication and reflect greater visibility and confidence.
Investors are more comfortable with a December hike than a September move and the November meeting is too close to the election to be live. The effective Fed funds rate has risen by around three bp over the past month to 40. If the effective Fed funds rate remains at 40 bp until the FOMC meets in December -- and the Fed does indeed hike -- then fair value for the December Fed funds contract is near 53 bp. The contract implies 49 bp. That is to say, nine bp (49-40) of a possible 13-bp move (53-40) or nearly a 70% chance that a December hike has been discounted.
Finally, a word about dissents. KC Fed President George -- having pulled her dissent in June -- has already indicated that she favors an immediate hike. Investors will regard the statement as more hawkish if George is not alone. We note that three voting members of the FOMC recently voted for a discount rate hike: Bullard, Mester and Rosengren. If there's more than a single dissent, it's likely to come from them.