Between the last FOMC meeting on January 25-26 and the next meeting on March 15, the world has changed dramatically. Middle East and North Africa revolutions fundamentally changed geopolitics. As a result, much higher risk premium on oil prices due to political uncertainties won’t go away anytime soon. The severe natural disaster in Japan destroyed thousands of lives and much of the economy in that region. The disaster is pulling the third biggest economy in the world on its way back into recession. On the other hand, the EU summit on March 11 decided to expand the European Financial Stability Facility (EFSF), allowing EFSF to buy EU government bonds and reduce interest payments for rescued countries.
Before the Japan earthquake, the market largely expected that the FOMC would address spiking oil prices and rising inflation expectations. The effects of Middle East conflicts have been priced in the market, given the soft oil price reaction toward news on the worsening situation in Libya before the Japan earthquake. NYMEX oil price gradually dropped from $105 to $102, as it became clear that the Libya civil war would last much longer than investors thought originally.
After the natural disaster, short term aggregate demand from Japan was expected to drop significantly since energy supply, transportation, manufacturing and infrastructure had all been severely damaged or even wiped out in disaster zones. The damage is not confined to the region destroyed by the tsunami. Shortage in electricity and dangers in nuclear plants also affected the rest of the nation. The current nuclear crisis threatens 20% of electricity supply in Japan, which is not easily replaceable. Disruptions in supply chains forced companies (i.e., car manufacturing and electronics) in other countries to find new suppliers. The sudden removal of huge demand from Japan, however temporarily, certainly allows the prices of commodities and raw materials to decline sharply for now.
However, after the initial stage of the rescue effort ends, Japan is going to rebuild the impacted regions. The massive rebuilding efforts will shift the level of demand for raw materials and energy higher than the pre-disaster level, which will push prices of commodities up again in next few months.
When FOMC members meet on March 15, they will surely notice impacts of uncertainties across the world on inflation and the U.S. economy. The temporary demand reduction won’t change the big picture that inflation pressure is building up and QE2 is on its way to the end. Nevertheless, I expect that FOMC will keep the usual soft tone on inflation and avoid the hawkish language used by their ECB counterparts, just to calm investors and keep risk appetites high.
Given the increasing risk in global markets, even a dovish FOMC statement probably cannot give investors much confidence. In the next few days, equity markets are more likely to continue trending down, while in the bond market, the yield curve should continue steepening.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
