The US Federal Open Market Committee unanimously decided to raise interest rates by another 25bp during last week monetary policy meeting, taking the fed funds rate to 5.25%. More interestingly, the statement language was a notch more dovish than expected. While the FOMC does not promise anything for the August meeting, the overall message is still that near-term monetary policy remains data dependent, the FOMC is still vigilant on inflation and has retained its tightening bias.

The FOMC’s assessment on the outlook for growth reflected recent softening in activity data, saying that “Recent indicators suggest that economic growth is moderating from its quite strong pace earlier this year…”. As in the previous statement, the slower pace of growth was attributed to “a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices”. Importantly, the committee still considered inflation expectations as contained, but acknowledged that, “core inflation has been elevated in recent months”.

The forward-looking part of the statement seemed a bit more balanced between growth and inflation than previously. It noted that, “although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain”. We are a little baffled by this more balanced signal in light of the Fed’s hawkish inflation campaign in recent weeks.

While the phrasing was more balanced, the statement kept a door open to further tightening by saying that, “The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information”. Importantly, this sentence explicitly links the near-term path of monetary policy to both inflation and economic growth, adding more balance to the statement.

Even though the current statement offers less guidance that previously, we still foresee a further 25bp rate hike in August, taking the fed funds rate to 5.50%, as we do not envisage any significant easing of inflationary pressures in the next couple of months. Beyond August we expect the pace of tightening to slow, as the pace of economic expansion will moderate in Q2/Q3 and the industrial cycle is set to soften in the summer and autumn. Further, the Fed is likely to be more cautious going forward, as it will be aware of the lagged impacts of the tightening carried out so far. However, as we expect inflationary pressures to keep building during the second half of this year and growth to pick-up again around year-end, we would pencil in a further hike to 5.75% in December or January. We see the fed funds rate eventually reaching 6% by Q2 2007.

SOURCE: Danske Bank