Dollar Dithers as QE Withers

The US dollar is narrowly mixed in quiet turnover.  The historic FOMC meeting that announces the end of QE is finally at hand.  This marks a new phase, post-QE, for monetary policy, and the US economy more broadly.  

Although there had been some jitters, investors have come around to expect the Federal Reserve to announce its commitment to end QE today. Not ending QE would potentially be more disruptive than ending it.  

It will complete the strategy announced by Bernanke before his term ended.  Up until now, Yellen has been executing the strategy, and neither the contraction in Q1 nor the strong jobs growth was sufficient to get her to alter course. Going forward, this is Yellen's Fed in a different way.  

The statement is the most important of the Fed's communication tools.  It is written or driven by the chair.  We argue Yellen is part of a triumvirate that drives Fed policy, and include Fischer and Dudley.  From them, the policy signal emerge.   

We expect today's statement to reflect that this centrist core remains in control.  That means the continued use to three word cues:  the "significant under-utilization" of the labor market, the "considerable" period between the end of QE and the first hike, and that the Fed funds rate may remain below what is regard as the long-term equilibrium level.  

Perhaps the most interesting part of the statement may be how the Fed addresses the decline in market-based measures of inflation expectations.  This part has potential to surprise investors.  If the topic is played down, or not even addressed, investors may feel more confident of a rate hike in the middle of next year, as Dudley, and others, have indicated is a reasonable scenario.  To the extent that the Fed expresses concern, it may encourage investors to continue to push out the first hike.  

At most, a bland reference to monitoring inflation expectations as expressed through various channels, may be expected.  The underlying principle in both the statement's forward guidance and its reference to inflation expectations is that without QE, communication maybe even more important. And to that end, whatever significant changes may be necessary, barring great urgency, can best be delivered when the Chair holds a press conference to help investors understand. 

The divergence between the US and Europe remains acute.  Today the Fed will take another step away from the emergency policies it pursued.  Sweden's Riksbank, which had been too cautious for too long, cut its repo rate to zero from 25 bp.  The market was looking for a 10-15 bp cut, and took the krona down in response.  

The central bank pushed out first rate hike from late next year to middle of 2016 at least.  It also recognized the lower inflation trend.  This is key.  It means that investors need to focus not so much on the real economy, but inflation measures.  

Unlike the euro zone which suffers from a stagnant economy and low inflation, Sweden's economy expanded at an annualized pace of a little more than 2% in the first half and is forecast to grow slightly faster in H2.  The September manufacturing and service PMIs (released in early October) were comfortable above the 50 boom/bust level, and unemployment is at the lower end of the range of the last couple of years.  CPI increased in Q2, but fell back in Q3.  The downtrend in inflation has not been achieved, despite reasonable growth,  .  

The ECB meets next week, and this week is about fiscal policy.  As early as today, the EC is expected to respond to the additional information it has received from several countries, and especially France and Italy, the second and third largest economies in EMU.  There are market rumors that France and Italy may have agreed to additional savings measures that will likely avoid a conflict.  Earlier talk suggested that Germany was keen to avoid a major confrontation, and there have been more reports that the rise in the AfD, may limit Merkel's perceived options.  

There are still two more central banks that will meet this week.  The Reserve Bank of New Zealand is most likely to keep rates steady while moving toward a somewhat less hawkish posture. The BOJ meeting may be more interesting.  Reports in the Nikkei indicate that the BOJ will likely cut this year's GDP forecast to 0.6% from 1.0%.  However, hopes that this will lead to a softer stance by Kuroda will likely be disappointed.  The BOJ is expected to leave FY15 GDP forecast unchanged at 1.5% and FY16 at 1.3%.   The BOJ's forecast is also likely to show core CPI, adjusted for the sales tax hike, hitting 2.0% in FY2015.  

Japan did report much stronger than expected September retail sales.  The 2.7% month-over-month increase contrasts with expectations for a 0.9% increase, after August's 1.2% rise.  However, this is too narrow of a measure to draw conclusions about the state of consumption post-tax.   Overall household spending, which will be reported on Thursday, is expected to have contracted 4.3% year-over-year and follows the 4.7% decline in August.  The bottom was hit in May at -8.0%.  

Industrial production is expected to rise, and exports appear to be improving.  Most measures of the labor market suggest some degree of tightness, except for wages, an international lament. Exports appear to have begun firming.  There is sufficient reasons for the BOJ not to be in a hurry to announce new measures.