The minutes from the FOMC’s January meeting reflect a clear concern regarding the downside risks to growth, but what about inflation? The FOMC touched on this by noting that improved prospects for growth could allow them to reverse previous rate cuts in order to “promote price stability.” However, Dallas Fed President Richard Fisher – a consistent inflation hawk – voted against the January 30 rate reduction, citing uncomfortably high CPI figures. Recent commentary suggests that he isn’t the only one worried, and traders aren’t as aggressive in their speculation about the Federal Reserve’s next move, though futures still price in a 90 percent chance of a 50bp cut on March 18. Moreover, with Fed Chairman Ben Bernanke’s testimony to the House Panel on Monetary Policy scheduled for Wednesday, these expectations could shift sharply.

Yield Spread Analysis 02/19 – 02/26

For the second week in a row, price action in the global fixed income markets has been very quiet as volatility in equity indexes has generally cooled down. Some exceptions include UK and Swiss bonds. Short-term yields on government bonds for the UK have jumped as the markets speculate that the Bank of England may not cut rates again in March, especially given the semi-hawkish commentary revealed in the minutes from the MPC’s February meeting.

This week, the release of Durable Goods Orders and Fed Chairman Ben Bernanke’s testimony to the House Panel on Monetary Policy could be a double whammy to Treasury yields, especially if orders plummet in line with expectations and if the markets perceive Bernanke’s commentary as being dovish. On the other hand, the emergence of more inflation-focused commentary could revive yields and the US dollar. Nevertheless, the former scenario is far more likely, and Treasury bulls and US dollar bears may simply be waiting in the wings to take action.

US Fed: Will Bernanke & Co. Switch Gears To Focus On Inflation?

The minutes from the FOMC’s January meeting reflect a clear concern regarding the downside risks to growth, but what about inflation? The FOMC touched on this by noting that improved prospects for growth could allow them to reverse previous rate cuts in order to “promote price stability.” However, Dallas Fed President Richard Fisher – a consistent inflation hawk – voted against the January 30 rate reduction, citing uncomfortably high CPI figures. Recent commentary suggests that he isn’t the only one worried, and traders aren’t as aggressive in their speculation about the Federal Reserve’s next move, though futures still price in a 90 percent chance of a 50bp cut on March 18. Moreover, with Fed Chairman Ben Bernanke’s testimony to the House Panel on Monetary Policy scheduled for Wednesday, these expectations could shift sharply.

“In the discussion of monetary policy for the intermeeting period, most members believed that a further significant easing in policy was warranted at this meeting to address the considerable worsening of the economic outlook...Still, with no signs of stabilization in the housing sector and with financial conditions not yet stabilized, the Committee agreed that downside risks to growth would remain even after this action. Members were also mindful of the need for policy to promote price stability, and some noted that, when prospects for growth had improved, a reversal of a portion of the recent easing actions, possibly even a rapid reversal, might be appropriate.” – Released February 20, 2008

“Mr. Fisher dissented because he preferred to leave the federal funds rate unchanged. The rate had been lowered by 75 basis points just one week earlier in a decision he supported, which brought the funds rate down 175 basis points since September. Given these actions, he felt that monetary policy was already quite stimulative, while headline inflation was too high at more than 3 percent over the last year...Given the policy tradeoffs confronting the FOMC at this time, Mr. Fisher saw the upside risks to inflation as being greater than the downside risks to longer-term economic growth, especially in light of the recent, aggressive easing of monetary policy and the lag before it would have its full effect on the economy.” – Released February 20, 2008

Richard Fisher, Federal Reserve Bank of Dallas President (Voting Member)

“The question is can we do our job right now? We have a weak economy. If you read through the forecasts... yes, there is a lowering of expectations for growth, but it is positive economic growth.” – February 25, 2008

Frederic Mishkin, Federal Reserve Governor (Voting Member)

“A key policy recommendation from the past three decades of research in monetary economics is that monetary policy makers must always keep their eye on inflation and emphasize the importance of price stability in their actions and communications. Doing so does not mean that monetary policy makers are less concerned about stabilizing economic activity. Rather, by appropriately focusing on stabilizing inflation along the lines I have outlined here, monetary policy is more likely to better stabilize economic activity.” – February 25, 2008

William Poole, Federal Reserve Bank of St. Louis President (Non-Voting Member)

“At any given time, policy-makers could pursue a powerfully expansionary policy to all but eliminate the possibility of a significant recession in the year ahead but doing so would come at the cost and even likelihood of an unacceptable increase in the rate of inflation. A substantial increase in the rate of inflation promises a larger recession later, as the country learned at such great cost in the 1970s.” – February 20, 2008

ECB: Still Focused on Price Stability, Still Worried About Growth

Like the US, the Euro-zone is grappling with downside risks to growth and strong inflation pressures, though the latter is now the more pressing concern. However, ECB President Trichet’s comment that world economies are “interdependent” suggests that he does not subscribe to the idea that a decoupling will take place where a recession in the US will not impact the Euro-zone economy severely. At the same time, it appears that Trichet is hoping that expansion in Asia will pick up the slack of the US, but if a decoupling does not take place, global growth will likely catch America’s cold and complicate monetary policy for the ECB even more.

Jean-Claude Trichet, European Central Bank President

"The world economy might be better able to rely on the dynamism of the Asia-Pacific region should growth in other regions lose momentum. This is particularly important at the current juncture…Since we are all interdependent, the key question therefore is to assess how, and to what extent, a possible slowing down in some mature economies might be partially offset by stronger growth in other regions, notably in emerging Asia." – February 26, 2008

Athanasios Orphanides, European Central Bank Governing Council Member

“We clearly don't have enough information about how the economy will evolve to determine whether it will be necessary to hike rates or to cut rates.” – February 22, 2008

“The euro area economy is doing quite well…(it) has not experienced the severity of the slowdown that has been seen in the United States.” However, there has been a “deterioration in the short-term projections as to inflation and to growth,” and “second-round effects would complicate our policy quite a bit. They also would complicate the ECB’s response to other shocks.” – February 26, 2008

Christian Noyer, European Central Bank Governing Council Member

“Our priority is preserving purchasing power, therefore fighting inflation…we will never choose to sacrifice purchasing power in the name of growth. To defend purchasing power is to support growth.” – February 20, 2008

Nicholas Garganas, European Central Bank Governing Council Member

“The impact on lending conditions and on the economic climate from credit market developments may be larger than expected. For this reason the ECB continues to all monitor developments with great attention.” – February 20, 2008

Joaquin Almunia, EU Economic and Monetary Affairs Commissioner

“Europe clearly begins to feel the impact of the global headwinds in terms of lower growth and higher inflation. (Europe's) increased resilience, thanks to the reforms already carried out, together with sound fundamentals, do help weather the storm.” – February 21, 2008

Richard Lee is a Currency Strategist at FXCM.