FOMC: Slightly Softer Tone

• As expected the Fed statement contained very few changes. The main difference was its characterisation of the "recovery proceeding at a moderate pace" compared to "recovery is on a firmer footing" which may be regarded as a slight softening.
• At the Fed's first press conference in its history Ben Bernanke maintained a fairly soft tone with an emphasis on the high unemployment rate. However, he stated that if inflation expectations were to rise, the Fed would have to respond.
• The growth forecast for 2011 was reduced but inflation estimate raised slightly.
• Given the modest rate of recovery, it will be a long while before unemployment moves down to the Fed's implicit target of 5½%. Significant fiscal tightening in 2012 and 2013 will provide a new headwind. Fed policy is therefore expected to remain very accommodative for a long time. We still do not foresee an initial rate hike until mid-2012.

Details

The Fed statement was largely a non-event although this was widely expected. The press conference did not provide much news either apart from a few interesting points.

Firstly, Bernanke stated that the Fed would complete its purchase program by June and continue to reinvest maturing bonds. He said that at some point - and early in the exit process - it would stop reinvesting though he stressed that it would constitute a tightening of policy and that it would have to be based on a judgement on the development of unemployment and inflation.

Secondly, he emphasised that although the labour market was gradually improving the level of employment was still 7 million below its pre-crisis level and that it remained in a deep hole. The Fed would like to see continued job creation for some time before becoming more comfortable concerning the sustainability of the recovery.

Thirdly, Bernanke said the Fed regarded weak Q1 growth as largely due to transitory factors although some, particularly construction, were having longer term implications. In response the 2011 forecast has been cut by ½ a percentage point.

Fourthly, on fiscal policy he remarked that the US clearly faces a serious long term challenge and that in that respect the change of outlook by S&P may be constructive in exerting pressure for necessary reforms to address long term issues. In response to a question he replied that to the extent fiscal tightening affected the Fed's mandate it would impact monetary policy. In other words, it seems clear that the additional headwind provided by fiscal policy means policy will remain accommodative for longer - all else being equal.

Finally, he declared that the Fed focused on inflation expectations for the medium term and that they were still anchored. He did add, however, that should they begin to increase the bank would have to respond.

Assessment and outlook

Overall we regard the statement as slightly more dovish compared to the March statement. With current headwinds affecting the recovery in the form of higher oil prices, significant fiscal tightening in the pipeline, and still well behaved inflation expectations we expect the Fed to favour caution, switching to a wait-and-see stance before considering an exit. An initial move will probably involve stopping reinvesting in late 2011. We still do not expect a first rate hike until mid-2012.

Market impact

Bond yields fell slightly in response and the dollar weakened further. With market pricing largely in line with our expectations we believe bond yields are broadly fair at these levels. A very steep curve and a patient Fed will make it hard for yields to go higher - not least as we expect to see ISM turn lower in coming quarters.

The combination of a soft Fed and continued ECB rate hikes supports further EUR/USD appreciation.