Flash Comment: Financial turmoil to delay Fed tightening

• The financial turmoil ignited by the crisis in Greece is likely to delay the normalisation of monetary policy in the US.

• Despite stronger-than-expected growth data, low and declining inflation pressure allows the Fed to move slowly ahead with policy normalisation.

• The Fed is now expected to deliver its first hike in January 2011 and start draining liquidity during H2 10.

Details

The financial turmoil in the wake of the crisis in Greece has highlighted that the financial system remains fragile and that problems that seem contained can suddenly spread.
Although the recent turmoil is not likely to have any significant impact on growth, we believe that the Fed will move ahead more cautiously than otherwise because of the risk of greater contagion.

In a response the Fed has re-opened the USD swap lines to foreign central banks effective until January 2011. This is likely to expand the Fed balance sheet over the coming months unless the central bank decides to sterilise it through open market operations. However, so far, there has been no information regarding this. Hence, the re-opening of the FX swap line is likely to be a de-facto easing of monetary policy and a step back in the process of normalising.

On top of these recent developments we have seen very little change in the language from central members (including Bernanke, Kohn, Warsh from the Board and Dudley from NY Fed) over the past few months. Finally, we have been a bit disappointed that there has not been a continued normalisation in the discount rate, which still remains 50bp below its usual 100bp spread to the fed funds rate.

Outlook and assessment

Even though growth indicators have been stronger than expected over the past few months and the risk of a slowdown in H2 has diminished, the recent turmoil in the markets is likely to delay policy normalisation.

Therefore we postpone the initial Fed hike from November 2010 to January 2011. This is likely to be preceded by discount rate normalisation and liquidity draining during H2 10. Following this change we now believe that the August 2010 meeting is the most likely candidate for meaningful moderation of the ‘extended period’ language.

A rate hike in January 2011 will still be on the early side compared to economic fundamentals, but we continue to believe that the Fed has a desire to move away from zero rates as a part of the normalisation process. Hence, rate hikes early next year are not likely to reflect the beginning of an aggressive hiking cycle, but merely a move away from crisis levels.