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December 10, 2005

Brace for Crucial Data/Fed Week
by Ashraf Laidi

Next week shall be the last full trading week of the year, but it will also be one of the most crucial if not most-data-event filled weeks of the year. In the US alone, markets will start off with Tuesday's FOMC meeting and November retail sales, followed by Wednesday's release of the October trade balance. Thursday's quadruple treat of the November CPI, October TICS data on net foreign capital flows, November industrial production/capacity utilization and the December Philadelphia Fed survey should provide a market moving mix of data on external accounts, manufacturing activity and inflation pace. Friday's release of the Q3 current account deficit should give a more comprehensive picture, but be ware of a one-time improvement in the report due to the payments by overseas insurers and unilateral transfers related to hurricane relief.

Will the Fed change tact?

Next Tuesday's FOMC decision should produce the 13^th rate hike of the 18-month long tightening campaign but it is the wording of the FOMC statement that once again should capture the interest of the markets on the basis that the Fed may need signal a near-term conclusion to the campaign. The importance of communicating a discreetly conveyed a message rests on fine-tuning the bond market reaction, without causing a bullish stir in equities or provoke interest renewed rate-driven optimism into the housing market.

The first question in mulling the Fed's statement is what reasons does the Fed have to signal a break in the current tightening? The second question is what changes should be signaled without the central bank placing itself in a policy bind from which it would be difficult to exit? Recall that the minutes of the November FOMC meeting triggered a broad dollar sell-off last month when they indicated that: "Some members cautioned that risks of going too far with the tightening process could also eventually emerge" and that "...policy setting would need to be increasingly sensitive to incoming economic data."

Furthermore, Fed policy makers agreed that in spite of the potential of the cumulative rise in energy prices and other costs to add to inflation pressures, "core inflation had been subdued in recent months and longer-run inflation expectations remained contained."

It's also worth noting that the latest Beige Book - released 8 days after the market-moving FOMC minutes - indicated that the Fed is increasingly nearing its objectives of stabilizing prices and cooling the housing sector without hampering growth. The description of consumer prices shifted from an overall pick up in the previous survey to "stable" and "modest increases" in the latest survey, while real estate changed from "all the districts ... noted rising demand for office, retail, or industrial space" to "Residential real estate activity was reported to have moderated in many Districts".

Considering the cooling in housing sales (new and home), the stabilization in energy prices and the ensuing stability in inflation (core PCE and core CPI both retreated to 2.0% y/y from their 2.2% and 2.4% respective highs for the year), it is fit for the FOMC to spell out a change by either introducing a time element to the pace at which accommodation is removed, or spelling out its data dependence as the basis of the continuation of its measured tightening.

What we suggest

Accordingly, we suggest the Committee could substitute the long standing phrase: "...the Committee believes that policy accommodation can be removed at a pace that is likely to be measured" with the following phrase "the Committee believes that policy accommodation has neared a level that is deemed to be neutral consistent with the balanced objectives of both sustainable growth and price stability". Then it would maintain the ensuing sentence indicating the Committee will respond to changes in economic prospects as needed to fulfill its obligation of price stability.

Making such a rhetorical change does not preclude the Committee from raising rates in January or February as long as it hedges it self with our suggested phrase of: "policy accommodation has neared a level that is deemed to be neutral". A rate hike in January would push up rates to 4.50%, which is in line with San Francisco Fed president Janet Yellen's own estimate of a neutral policy, which she put at 3.50%-5.50%.

The knee-jerk reaction of any change in the statement should be dollar negative as was the case after the release of the Nov 22 minutes, when the EURUSD gained as more than a full cent and the yen pushed up over 70 pips. Carry trade enthusiasts are eyeing any change in signals from the Fed that would add some finality to the accumulation of the dollar's yield luster. Such a change would signal this possibility and erode call up the $1.19 level in the euro and 119.30-50.00 yen level.

With the Bank of Canada leaving the door open for as many as 50 bps of tightening in Q1, and the ECB with at least 25 bps in the same period, the unwinding of the carry trades could never be worked out so accurately. Rising expectations for the end of Japan's deflation by end of March and could also reestablish the hedging of long dollar positions by Treasury-bound Japanese as the US yield curve would likely begin steepening when the Fed reaches a pause.

The ECB's own version of "measured" tightening

Although ECB president Jean-Claude Trichet asserted that last week's 25-bp rate hike was not necessarily going to be followed by a series of similar moves, Thursday's series of hawkish remarks from the Irish and German central bankers as well as earlier comments from Chief economist Issing, clearly pushed back the door open for further tightening. The ECB officials explicitly stated that further deterioration of the price outlook would have be addressed with a rate hike at any time. This was also a clear message to the increasingly vocal politicians, who have expressed their unanimous opposition to last week's rate move.

We believe that one variable that is hardly mentioned (but largely mulled) by the ECB in addressing price stability is the euro's exchange rate. Should the EURUSD pair remain within the range of the last 5 weeks ($1.1670-1.1900) then a cheap currency is more likely to lubricate the Euro inflationary machine and trigger a rate hike as early as January. If on the other hand the currency rises past the $1.20 figure and maintains its 7-year high run against the yen, then a rate hike is expected to be less tenable.

Ashraf Laidi
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