NEWS / Foreign Exchange

Fed Open ed Market Committee, October 30-31st

In his speech at the HEC-Montreal International Transmission and Macroeconomic Policies Conference, Fed Governor Frederic Mishkin discussed the advantages of using monetary policy rules that focus on core inflation rather than headline inflation, mainly because of the inherent volatility of this indicator. In our interpretation, if monetary policy focuses on headline inflation it will not only increase overall price level volatility but it will induce employment volatility as well. For example, a tightening of monetary policy in reaction to a temporary increase in headline inflation would lead to increased volatility in output and inflation, which is against the Fed??™s ultimate goal of stability and maximum sustainable employment.

In our view, Mishkin presented a solid argument for the use of monetary policy that focuses on core inflation and he explained the significance of these inflation indicators on the future of monetary policy and specifically changes to the Fed funds rate. Current readings on core inflation published by the Bureau of Labor and Statistics on October 17th, showed that the consumer price index excluding food and energy increased by 2.3 percent during the first three quarters of 2007, compared to a 2.6 percent increase during the same quarters of 2006, which is consistent with a deceleration of core inflation (see: BBVA September Inflation Observatory). The main contributors to this deceleration are a lower price index for shelter and a significant reduction in the index for apparel during the first nine months of 2007.

Fed Chairman Ben Bernanke gave a speech at the St. Louis Fed 32nd Economic Policy Conference on monetary policy under uncertainty. He cautioned that while many market participants believe that gradual adjustments to the Fed funds rate are the optimal policy under a scenario of higher uncertainty (this has been, historically, the most accurate way to describe the Fed??™s approach) the possibility of a drastic cut can not be completely ruled out in light of recent theoretical developments.

We believe that interest rate cuts could be less effective than they used to be due to changes in the monetary transmission mechanism. The ongoing correction in the housing markets and the spillover effects on the broader economy could lead to a situation in which the Fed might adjust rates aggressively rather than gradually.

Our expectations are consistent with a scenario in which the Fed assigns more weight to the downside risks to growth. We maintain our previous forecasts of inflation and fed funds rates for the fourth quarter of 2007.

In summary, we maintain our expectations of a FOMC rate cut of 25 bp next week. In addition, another rate cut might occur at the December meeting. Thus, we maintain our forecast of a total reduction of 50 bps to 4.25% by year end.