The release of the minutes from the FOMC’s August 7 meeting didn’t shed any new light on the central bank’s policy stance, as the meeting occurred just days before market volatility spiked and risk aversion started to reign on August 9. However, the minutes did show that the FOMC was concerned enough about worsening financial conditions to say that they may need to take policy action. As a result, the FOMC’s policy decision on September 18 appears to be dependent mostly on how the financial markets perform until that time, leaving the door open to a potential rate cut.
This Week In Central Bank Speak:

Yield Spread Analysis 08/21 – 08/28

As volatility has cooled throughout the markets during the past week, government fixed income instruments have followed suit and have sent short-term bond yields rocketing higher. However, 10-year yields have not been as fortunate, leading yield curves in the US, Europe, Canada, and the UK to invert quite a bit. The reason? Bonds with shorter maturity times are more sensitive to changes in monetary policy and have reacted to the fact that many central banks have turned from holding a hawkish stance to either neutral or slightly dovish stances following the spike in volatility.

Looking ahead, traders should be keenly aware of risk aversion trends, as this has been the main driver of price action in equities, bond, and forex markets. However, US event risk in the form of GDP on Thursday could shake up Treasuries, especially if it shows a sharp revision. Furthermore, Fed Chairman Bernanke will speak in Jackson Hole, Wyoming on Friday, and any comments on housing, credit markets, or inflation has the potential to spark major price action.

US Fed: Rocky Market Conditions Could Drive the Fed to Cut in September

The release of the minutes from the FOMC’s August 7th meeting didn’t shed any new light on the central bank’s policy stance, as the meeting occurred just days before market volatility spiked and risk aversion started to reign on August 9th. However, the minutes did show that the FOMC was concerned enough about worsening financial conditions to say that they may need to take policy action. As a result, the FOMC’s policy decision on September 18th appears to be dependent mostly on how the financial markets perform until that time, leaving the door open to a potential rate cut:

Minutes from the Federal Open Market Committee's August 7th Meeting

“Participants generally expected that core inflation would edge lower over the next two years...But they were concerned that the high level of resource utilization and slower productivity growth could augment inflation pressures.”

"Participants agreed that the housing sector was apt to remain a drag on growth for some time and represented a significant downside risk to the economic outlook."

"...a further deterioration in financial conditions could not be ruled out and, to the extent such a development could have an adverse effect on growth prospects, might require a policy response."

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

“I don't mind tears among individual market operators, as long as we don't get tears in the fabric of the financial system…I do not believe the Federal Reserve's job is to protect against the failure of specific risk-takers. Its job is to protect the system…When the yield on highest quality credits are low, all kinds of 'new paradigms' spring forth in search of greater returns. When they do, investors and financial agents too often forget the difference between price and value.” – August 23, 2007

Angelo Mozilo, Countrywide Financial Corp Chief Executive

“I've seen this movie before, and the ending of the movie always ends up in some form of recession…I can see the economy slowing down substantially enough to give the regulators, the Fed some pause in what's going to happen next…The Fed has cut the discount rate and added liquidity to the markets but those things aren't enough to turn the fundamental market around.” – August 24, 2007

ECB: Will Trichet Assert Strong Vigilance On September 6?

European Central Bank President Jean-Claude Trichet has been summoned to a special meeting of the European Parliament's Committee on Economic and Monetary Affairs on September 11th, as the group sounds concerned and wants to discuss the decline in credit supply and turmoil in financial markets. However, the meeting will occur after the ECB’s next policy meeting on September 6th, raising the question: will Trichet want to leave rates on hold until market volatility dies down and in order to discuss his policy plans with the committee first? Or will a jump in money-supply growth in the Euro-zone to a 28-year high of 11.7 percent persuade the bank to hike 25 basis points to 4.25 percent?

European Parliament's Committee on Economic and Monetary Affairs

“The committee is particularly interested in the monetary-policy decisions to be taken by the ECB's Governing Council in reaction to the financial turmoil…further attention needs to be given to transparency and regulation of entities engaged in the excessive risk taking, such as hedge funds and private equity as well as to the role of the credit rating agencies.” – August 28, 2007

Recent commentary by Trichet suggests that he has no definite plan for September 6th:

Jean-Claude Trichet, European Central Bank President

“What I said on the second of August [when he used the phrase ‘strong vigilance’] was before the market turbulence…the next assessment is to be made on September 6. We will then have to assess all of the elements of…the economy. We will assess the risks…and will take the appropriate steps at that moment.” – August 28, 2007

BOJ: Will A Determined Fukui Dare To Raise Rates This Year?

While markets are currently expecting most central banks to cut rates or hold off on previously expected rate hikes this year, Bank of Japan Governor Toshihiko Fukui is widely perceived as remaining determined to secure his legacy of “normalizing” monetary policy after putting an end to ZIRP in 2006, despite the fact the economy still teeters on the edge of deflation. While many fiscal officials pay heed to the BOJ’s independence, Fukui faces clear opposition from some political officials:

Toshihiko Fukui, Bank of Japan Governor

“There is no reason the BOJ should not press ahead with its rate-raising strategy if the economy remains shielded from the current financial market turmoil.” – August 23, 2007

“It may be too late if we wait until every piece fits into a jigsaw puzzle to conduct policy.” – August 23, 2007

Toshiro Muto, Bank of Japan Deputy Governor

“Funds flowing into Asian economies have pushed up real-estate and stock prices and could fan inflation…These situations could pose a threat to price stability over the long term and may affect the stability of the financial system…From this perspective we need to closely monitor developments.” – August 28, 2007

Hiroko Ota, Japanese Economic and Fiscal Policy Minister

“Monetary policy is in the domain of the Bank of Japan…We want the bank to firmly support the economy from the financial side.” – August 28, 2007

Hidenao Nakagawa, Secretary General of the Liberal Democratic Party

“As the ruling party, we are in a position to request that the government and the BOJ sufficiently coordinate their policies.” – August 24, 2007

Terri Belkas is a Currency Strategist at FXCM.