Predicting FOMC Response on Increasing Risk in Global Economy

Between last FOMC meeting on January 25-26 and next meeting on March 15, the world had changed dramatically. Middle East and North Africa revolutions fundamentally changed geopolitics in that corner. 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 economy in that region. It 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), allow EFSF to buy EU government bonds, and reduce interest payments for rescued countries.

Before Japan earthquake, market largely expected that FOMC would address the spiking oil price and rising inflation expectation. Effects of Middle East conflicts have been priced in market, given the soft oil price reaction toward news on the worsen situation in Libya before Japan earthquake. NYMEX oil price gradually dropped from $105 to $102, as it became clear that Libya civil war would last much longer than investors thought originally.

After the natural disaster, short term aggregate demand from Japan would 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 nation. 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 suddenly removal of huge demand from Japan, however temporarily, certainly makes prices of commodities and raw materials decline sharply for now.

However, after the initial stage of rescue effort ends, Japan is going to rebuild the destructed region. 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 US 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 market would be more likely to continue trending down, while in bond market, the yield curve should continue steepening.

By Zhong Jin

This article may include mentions of rumors, chatter, or unconfirmed information. Readers should beware that while unconfirmed information may be correlated with increased volatility in securities, price movements based on unofficial information may change quickly based on increased speculation, clarification, or release of official news.

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