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FOMC not likely to give ground on its hawkish intentions
U.S. housing starts expected to rebound mildly higher despite Harvey
U.S. import prices expected to gain some steam due to the weak dollar
U.S. current account deficit expected to narrow mildly

FOMC not likely to give ground on its hawkish intentions — Several FOMC members have recently expressed their concern about weak inflation measures, even though Fed Chair Yellen insists that the weakness in inflation is transitory. Indeed, the market about two weeks ago downgraded the odds for a Fed rate hike by December to only 38% due to the weak inflation outlook and then-incoming Hurricane Irma. However, the odds have since rebounded higher to 64%, according to the Jan 2018 federal funds futures contract, due to (1) the 13 bp rise in the 10-year breakeven inflation rate to a 4-month high of 1.87%, (2) rising crude oil prices, and (3) the rise in the Aug CPI to +1.9% from June’s 11-month low of 1.6%. The FOMC this week is likely to keep its general language little changed and keep its intention live for a rate hike in December.

For today’s meeting, however, the market is discounting a negligible 12% chance for a Fed rate hike. The FOMC’s main job this week is to get its balance sheet reduction program underway with the announcement of an official start date. A start date of October 1 makes the most sense so that the program is synchronized with calendar quarters. The FOMC has already announced that the program will cap security roll-offs at $10 billion per month to begin. The cap will then rise by $10 billion every three months until the maximum cap of $50 billion per month is reached.

The Fed has clearly telegraphed its balance sheet intentions and this week’s start-date announcement is not likely to have any major impact on the markets. Indeed, the Fed is hoping that the balance sheet reduction program will be like “watching paint dry,” as Ms. Yellen has said. However, if there was a positive impact on the economy and asset prices from the Fed’s three QE programs, then the corollary is that the drawdown of the Fed’s balance sheet will have somewhat of a negative effect as liquidity is slowly drained from the banking system.

Aside from the expected balance sheet start-date announcement, the markets will be closely watching for any change in the language in the FOMC’s post-meeting statement and for any dovish shift in the Fed-dot forecasts. The last set of Fed dots forecasted three rate hikes per year from 2017 through 2019, leaving the funds rate at the terminal level of 3.0% by the end of 2019. That is far more hawkish than the market view, which is looking for a funds rate of only 1.65% at the end of 2019, up by only +52 bp from the current target mid-point of 1.13%. The market is therefore currently looking for only about two +25 bp rate hikes over the next 2-1/4 years, while the Fed is looking for seven rate hikes.

Fed Chair Yellen tomorrow will give a press conference after the meeting, giving her the opportunity to more fully explain the Fed’s balance sheet goals. Other key questions will be her inflation outlook and the Fed’s assessment of hurricane impacts. The Fed has not yet announced how far it intends to allow its balance sheet to drop or how long its balance sheet reduction program will last. That depends in large part on how the Fed in coming years intends to conduct monetary policy, i.e., with a floor or a corridor type system.

U.S. housing starts expected to rebound mildly higher despite Harvey — The market consensus is for today’s Aug housing starts report to show a +1.7% increase to 1.175 million, rebounding somewhat after July’s -4.8% decline to 1.155 million. The housing starts series in July was -13.0% below the 10-year high of 1.328 million posted in October 2016, but most of that weakness was in multi-family starts as seen by the fact that July’s single-family home starts figure of 856,000 units was only -2.4% below February’s 9-3/4 year high of 877,000 units.

Housing starts in August would have likely seen a larger upward rebound if Hurricane Harvey had not struck Texas on Aug 25, causing delays in home construction. Yet after some infrastructure cleanup, housing starts in Texas and Florida should see a surge of construction as damaged homes are rebuilt, thus giving the U.S. housing sector even more strength that it has now.

U.S. import prices expected to gain some steam due to the weak dollar — The market consensus for today’s Aug import price report is for a fairly strong increase of +0.4% m/m and +2.2% y/y, which would be up from July’s +0.1% m/m and +1.5% y/y. Excluding petroleum, Aug import prices are expected to strengthen by +0.2% m/m and +1.0% y/y from July’s report of unchanged m/m and +0.9% y/y.

U.S. import prices have stalled in the past several months with virtually no net change since February. However, U.S, import prices should start displaying some upward pressure in coming months as this year’s sharp decline in the dollar puts pressure on importers to raise prices to cover currency depreciation. Higher import prices should give the overall U.S. inflation statistics an upward boost in coming months, perhaps encouraging the Fed to go ahead with a December rate hike.

U.S. current account deficit expected to narrow mildly — The market consensus is for today’s Q2 current account deficit to narrow mildly to -$112.4 billion from -$116.8 billion in Q1. The expected Q2 deficit of -$112.4 billion would be slightly wider than the 8-quarter average of -111.9 billion. The U.S. current account deficit has been widening mildly over the past three years, but has been little changed as a percentage of GDP near -2.4%. The U.S. current account deficit continues to be a mildly bearish long-term factor for the dollar since a net $1.3 billion worth of dollars are flowing out of the U.S. every calendar day. However, that is a pittance compared with the size of daily trading in the global forex market and is easily absorbed.

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