The latest Minutes of the Federal Open Market Committee (FOMC) paint a rosy picture of a solid economic expansion that is seen on a steady path after a temporary slowdown in the 4th quarter of 2005. Repeated statements about the robust economy are likely to clear the path for further rate hikes, mainly because of inflationary dangers from persistently high energy prices which will affect the so called core inflation rate negatively over the course of the running year before subsiding again in 2007. But take note that the Fed has been hoping for oil prices to fall since they crossed the $40 level. Energy prices will probably remain the single biggest danger to economic growth and ongoing anti-Western protests in the Islamic world as well as the steadily rising tensions between the USA and Iran do not exactly appear to help ease oil prices.
Markets were slow to react to the FOMC minutes. Both bonds and shares held on to the slightly negative tone that had dominated trading before the release.
Key passages from the Minutes:
The staff forecast prepared for this meeting suggested that, after slow growth in the fourth quarter of 2005, real GDP would expand at a fairly robust pace over the first half of this year, boosted in part by spending on recovery activities associated with the hurricanes. Thereafter, real GDP growth was expected to moderate, importantly reflecting a reduced impetus to consumption from house price appreciation and some slowing in residential housing expenditures. Core PCE inflation was expected to be a touch higher this year than in 2005, largely because of the pass-through of higher energy and nonfuel import prices, but, with energy prices leveling out, core inflation was projected to drop back modestly in 2007.
In preparation for the Federal Reserve's semiannual report to the Congress on the economy and monetary policy, the members of the Board of Governors and the presidents of the Federal Reserve Banks submitted individual projections of the growth of GDP, the rate of unemployment, and core consumer price inflation for the years 2006 and 2007. The forecasts of the rate of expansion in real GDP for 2006 were in a range of 3-1/4 to 4 percent, centered at 3-1/2 percent, while those for 2007 were in a range of 3 to 4 percent, with a central tendency of 3 to 3-1/2 percent. These rates of growth were associated with projections of the civilian unemployment rate in a range of 4-1/2 to 5 percent, with a central tendency of 4-3/4 to 5 percent, in both the fourth quarter of 2006 and the fourth quarter of 2007. Expectations for the rate of inflation, as measured by the core PCE price index, were in a range of 1-3/4 to 2-1/2 percent this year, centered at about 2 percent, and in a range of 1-3/4 to 2 percent in 2007.
Participants noted that, while the pass-through of higher energy and other commodity prices to prices of core goods and services had remained subdued, there were continuing upside risks to inflation from these sources. Whatever the size of such pass-through effects, however, it was thought that they would probably be temporary in nature and likely diminish as energy prices flattened out, as long as inflation expectations did not move higher. In that regard, participants were encouraged that, despite recent energy price increases, survey measures of inflation expectations had notched down and longer-term inflation compensation in financial markets was little changed. Although high profit margins could imply some existing pricing power, they might also provide a cushion to absorb some future cost increases. Indeed, anecdotal reports suggested that the ability of firms to pass through higher input costs generally remained limited. Nevertheless, the increased prices of energy and other commodities and the possibility of a further rise in resource utilization, which some members viewed as nearly full at present, represented continuing risks, potentially adding to inflation pressures.
All in all the picture has not changed that much, but the hawkish tone detected in the statement from the last FOMC meeting got confirmed by these Minutes. See Fed Funds somewhere between 5.25% and 5.75% later this year.