FOMC Preview: Fed's Hands are tied

• We expect the Fed to sound soft on growth but it may change its description of inflation to a more hawkish direction.
• The Fed's hands are tied for QE3 and will signal this in the press conference. This may be a slight disappointment and bond yields are expected to rise slightly in response.

Fed to downgrade growth outlook

The news flow since the latest meeting has been very weak and the Fed is set to downgrade its outlook for GDP. The key phrase in the statement on the recovery in April said: “the economic recovery is proceeding at a moderate pace and overall conditions in the labour market are improving gradually”. The Fed will change the wording here and likely point to the recent weakness. But at the same time points out that transitory factors are behind the slowdown and the recovery is expected to continue at a moderate pace. Despite the weaker data the Fed's hands are tied by the rise in inflation recently. And the Fed may have to change its description of inflation. The key phrase on inflation in April was “Inflation has picked up in recent months, but longer-term inflation expectations have remained stable and measures of underlying inflation are still subdued”. However, core inflation has now risen to 1.5% y/y up from 0.6% in October last year. And looking at the shorter term momentum the six month annualised core inflation rate now stands at 2.1% after hitting 0.3% early last year. Overall it may be difficult for the Fed to hang on to the description of underlying inflation as being subdued and we see a chance this will change to being in line with the Fed's mandate.

Further on, the Fed will likely stick to the phrase that “longer-term inflation expectations have remained stable...” and continue to state that “it will pay close attention to the evolution of inflation and inflation expectations”.

The Fed chairman Ben Bernanke will likely sound quite dovish on the growth picture - as he normally does. However, we don't expect Bernanke to open any doors for another round of monetary expansion (QE3) because: a) The slowdown is expected to be temporary; b) The inflation picture is not as favourable as when the Fed introduced QE2; and c) There is disagreement within the Fed as to whether QE2 has been a success or not.

Policy outlook: Fed on hold until mid-2012

Going forward we expect the Fed to stay sidelined for a very long time. Inflation is too high and growth not weak enough to add stimulus. But the recovery is not strong enough to start raising rates. We continue to look for the first hike in mid-2012.

The market, however, has pushed the expectation for the first hike to November 2012 and hence we see very little value in US bonds. When we get through the soft patch and data improves we look for higher yields.

Market reaction

We don't expect any major surprises and hence market reaction should be limited. If anything, the market may be slightly disappointed that the door is firmly closed for QE3 and hence bond yields should rise a little.

FOMC statement of 27 April 2011

Information received since the Federal Open Market Committee met in March indicates that theeconomic recovery is proceeding at a moderate pace and overall conditions in the labour market are improving gradually. Household spending and business investment in equipment and software continue to expand. However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed.

Commodity prices have risen significantly since last summer and concerns about global supplies of crude oil have contributed to a further increase in oil prices since the Committee met in March. Inflation has picked up in recent months, but longer-term inflation expectations have remained stable and measures of underlying inflation are still subdued.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The unemployment rate remains elevated and measures of underlying inflation continue to be somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Increases in the prices of energy and other commodities have pushed up inflation in recent months. The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations. The Committee continues to anticipate a gradual return to higher levels of resource utilisation in a context of price stability.

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and will complete purchases of USD600bn of longer-term Treasury securities by the end of the current quarter. The Committee will regularly review the size and composition of its securities holdings in light of incoming information and is prepared to adjust those holdings as needed to best foster maximum employment and price stability.

The Committee will maintain the target range for the Federal funds rate at zero to ¼% and continue to anticipate that economic conditions, including low rates of resource utilisation, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the Federal funds rate for an extended period. The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo and Janet L. Yellen.