The FOMC meeting is the most important economic event next week.  The implications are much broader than the impact on the US dollar, which has surprisingly not reacted to the recent string of strong economic data.

This month’s FOMC meeting had previously been widely seen as a likely timeframe for the first rate hike.  The unexpected weakness in GDP and the well-below trend job growth in March help shift sentiment to September.  This month’s Wall Street Journal survey showed 72% of economists expect that.

What follows from this is that neither the FOMC or Yellen at her press conference will indicate otherwise.  To do this, the Fed will have to recognize that what will eventually appear as stagnation in Q1 appears to be proving temporary as it had anticipated.  This will likely mean a reduction of the “central tendency” of Fed forecasts, by which a few highs and lows are dismissed, and an average taken of the remainder.  In March, it was 2.3%-2.7%  (2.5% midpoint, which after the recently updated forecasts is precisely what the IMF forecasts).

Tactically, it would be best for the Federal Reserve is they avoided being in a position to cut its growth forecasts again in September.  It would not be helpful in the context of both the IMF and World Bank recent assessments that the Fed should wait until next year to raise rates.  On the other hand, a central tendency of below 2% might be taken as a signal that the doves are prevailing.

There are three points in this context that does not seem sufficiently recognized.  The first where does the power lie at the Federal Reserve.    In a recent blog post, Bernanke argued against a notion put forward in an op-ed piece in the Wall Street Journal that the key to policy will be the Board of Governors.  Benn Steil argued this because that is where the interest rate on excess reserves is set, which will be a key tool in monetary policy as it is normalized.    Bernanke explained how there are no competing interests and how the direction was set by the FOMC in practice.

Bernanke accepts that the influence of individual members vary both formally (permanent votes) and informally (such as persuasiveness).  We have argued that the key policy signals emanate from three members: Yelllen, Fischer, and Dudley.  It follows from this that the FOMC statement, crafted by the Fed’s leadership, is the single best source of insight into the Fed’s thinking.  It means that the dot plots are noisy, as are the minutes.  Yellen’s press conference comes in close second as she candidly explains how the FOMC statement should be read.

Where Steil is correct, though is that a dissent from a Governor is more significant than from a regional Fed President.  There have been no dissents at this year’s first three meetings.  This is unusual, and is likely to change, if not this week, in Q3.  Forging a consensus for action is difficult.  The hawks want lift off sooner and the doves later.

The second point that seems to be under-appreciated is that the underlying trend rate for the US economy has slowed considerably in recent years.  The two key elements are the labor force growth and productivity.  The growth of both has diminished.   Under the Fed’s forecasts made in March, Yellen noted that the Fed was still anticipating above trend growth.

The “escape velocity” hypothesis has been undermined.  The moderate year-over-year growth has been sufficient to absorb the slack in the labor market because moderate can only be understood contextually.  That moderate growth is above the rate of labor forces growth and productivity.

The third point is about the dollar.   While the level of the dollar may be important for the competitiveness of some businesses, but is more important for policy making is the pace of change. The dollar’s dramatic appreciation in Q1 compelled the Fed to discuss it more in their deliberations. It has stabilized since the Fed last issued updated its forecasts in March.  Consequently, the dollar is not as important as it was then.   As the Fed has anticipated, its impact appears transitory.  The settlement of the port strike and the stabilization of the dollar means that net exports will not be nearly as large of a drag as it did in Q1 (subtracted almost two percentage points from GDP).

Three top officials spoke in recent days, and their comments on the foreign exchange market caused some consternation.  First, an unnamed, apparently French official claimed that Obama expressed concern about the dollar’s strength. Many cited this as the reason there was not follow through dollar buying after the strong employment report.  Denials by the White House and Obama himself did not prevent many in the media from continuing to cite this as an example of the currency wars.

Our understanding of the US position is that countries should not rely on the exchange rate to “steal” US aggregate demand.  The solution does not lie in an adjustment of exchange rates, but more effective stimulative measures and structural reforms in Europe and Japan.   The US Treasury’s recent report on the foreign exchange market and the international economy said as much.

In the Financial Time’s report on the currency wars, it left out the comments by BOJ’s Kuroda. Kuroda said the real effective yen exchange rate is near what he thought could be a significant low.  The market, which had been accumulating a large short yen position, scrambled to buy the yen back.  The subsequent clarifications did not change the substance but emphasized the lack of intent.

The BIS tracks real effective exchange rates (REER).  The yen’s REER reached a low just below 73 in 2007 and proceeded to rally to at least 30-year highs in early 2012 to 111.50.  Over the last three years, it has fallen back and were below 77 now.  That low in 2007 was the lowest in about a decade when the yen’s REER briefly was below 69 in both 1997 and 1998.  Kurdo’s reiterated a point made by other officials; namely that the yen’s over-valuation has largely been corrected.  This does not fit into the currency war narrative.

Toward the end of last week, German Chancellor Merkel made rare comments about the euro’s exchange rate.  In the context of her remarks, the reference was part of her effort to explain to German businesses why the ECB’s monetary policy is important.  The real signal was not about the exchange rate, but a subtle criticism of the Bundesbank that has fought the ECB tooth-and-nail.  She said more about Berlin’s relationship with Frankfurt than the euro’s relationship to the dollar.  Even though the euro initially was sold on Merkel’s comments, it quickly recovered.

Merkel said that the ECB’s monetary policy helped to contain the rise of the euro, which benefited countries such as Spain and Portugal, who have implemented structural reforms but could not derive much benefit.    There comments were not prescriptive or normative, but descriptive of what has happened.  It late 1997, Spain’s real effective exchange rate was a little below 90.  It appreciated from 2000 to 2008 when it peaked near 105.5.  Now is at 93, the lowest since 2002.

There is another metric that also suggest Merkel was not talking about Spain today, but justifying the ECB’s policies, of which some of her allies have been critical. Spanish exports reached a record high in March (the most recent data available) of 20.2 bln euros.  This coincides with the 12-month average.  In contrast, exports averaged 18.6 bln euros a month in 2012 and 15.5 bln euros a month in 2010.  Spanish exports have grown faster than world trade. Thus, it accounts for a larger share of world exports.

In addition to the Federal Reserve, the Swiss National Bank, and Norway’s Norges Bank also meet. The SNB is not expected to put rates deeper into negative territory (3m LIBOR target is -75 bp).  The shock from the appreciation of the franc seems to be preventing Switzerland experiencing the waning of deflationary pressures throughout much of the high-income countries.  Eurozone deflation has ended as has Sweden’s.  The May US CPI is expected may be slightly positive for the first time this year.  UK CPI was flat in April, but also likely picked up in May.

Norway’s central bank was expected to cut interest rates in response not so much to lowflation, but because of the weakness of the domestic economy.  However, news last week that the oil sector’s capex was not as poor as had been anticipated.  This spooked the market and spurred a short squeeze that lifted the krona over 1% against the euro.   We are unpersuaded, and still see the risk of a rate cut.  Their 1.25% deposit rate is still the highest in Western Europe.  Among the high-income countries, only Australia and New Zealand’s policy rates are higher.

The ECB does not meet, but it will offer banks the fourth opportunity to access the Targeted Long Term Repo facility.  The borrowing is tied to net lending, which has gradually improved.  Most estimates are for banks to borrow less month than they did at the March offering (~97.8 bln euros).   There did not seem to be much of a reaction to the news in March, even though banks borrowed well more than expected.  Given the backup in yields, sovereign bond purchases (carry trades) look more appealing than they have.  On strong participation, it would not be surprising to see European bonds rally, especially the higher yielding bonds such as those of Spain and Italy.

As tired as officials may be of discussing Greece, the fact of the matter is that it will dominate the Eurogroup meeting next week.   Here we are at the end of H1, and the economy and banks are deteriorating.  Greek banks are thought to be rapidly running out of collateral to borrow under the ELA facility.  The June payments to the IMF are onerous enough, but next month the sums turn significantly larger as the ECB’s bonds have to be serviced.

While Greece would suffer a deep economic contraction, a surge in unemployment, and what the Syriza government has called a humanitarian crisis on an exit from monetary union, it would ultimately be a failure of European leadership.   EMU is reversible; and if it is for Greece, why not Spain is the anti-austerity Podemos gains sway, or if the Socialists outflank it and absorb its agenda?

The risk of a failed state on the EU’s southern flank, in terms of the consequences for immigration, defense, and the ability to block a Russian pipeline alternative to Ukraine, would likely be more costly for Europe in the medium and long run.   How should one evaluate the cost of a Russian naval base in Greece, where the possibility can only rise if it is forced out of EU and EMU. Would its NATO membership be secure?

Before the weekend S&P cut the outlook for the UK’s credit rating to negative from stable.  It cited the plans for an EU referendum, which puts at risk, it says, to the growth prospects of UK financial services, export sector, and the wider economy.  While the timing of the announcement was surprising, the market did not seem to react much. The benchmark 10-year gilt finished below 2.0% for the first time since June 2.  Sterling closed at its best level since May 21.

Also before the weekend, the US House of Representatives failed to pass measures that would grant Obama trade-promotion authority.  The markets did not seem to respond.  It is not clear whether this is a short-term glitch, like what took place in the Senate before approval was given a few days later, or a critical defeat.  A defeat would be a blow of Obama, and undermines the economic compliment of the pivot to Asia.  Japan’s Prime Minister Abe had also come to embrace the TPP as a way to push his domestic reform agenda.


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