Greenspan key for dollar and interest rates outlook

The key event this week will be the Congressional testimony by Fed Chairman Greenspan. This is Greenspan's semi-annual testimony (formerly known as Humphrey-Hawkins testimony) on the US economy, presented to the Senate Banking Committee on Wednesday (10am local time) and to the House Financial Services Committee (also 10am local time). Historically, this testimony can elicit a strong market reaction, and the question and answer period in each session can have just as much market moving influence as the prepared remarks (which are the same to both the Senate and the House).

In the past, Greenspan has used this testimony and question and answer period to hint at the outlook for monetary policy and/or signal a change in monetary policy. This time around however, we see little reason to expect Greenspan to deviate from the recent FOMC script that monetary policy remains accommodative and that the accommodation can likely be removed at a measured pace.

In fact, we would not be surprised to see the bulk of the questions to Greenspan focus on the high-profile policy issues of fiscal restraint, social security reform, and the USD/trade deficit outlook. All three of those issues are attracting considerable attention in Washington, and members of Congress will likely use the opportunity to press Greenspan for his own views. That will be especially true on President Bush's goal of creating private retirement accounts, which is a highly charged issue these days, and also on revaluation of Asian currencies.

Also note that at this testimony, Greenspan reports the Fed's latest economic forecasts. At his last testimony in July 2004, he presented the following views for 2005. The central tendency for real GDP growth and the core PCE deflator was 3.5 - 4.0% and 1.5 - 2%, respectively. Both of those forecasts are on a Q4/Q4 basis. (The broader estimate for inflation in 2005 is 1.5 - 2.5%.) The average unemployment rate in Q4 2005 was forecast to be 5.25% - 5.5%. At the time, we commented that those forecasts are consistent with our view of slack in the labor market, which will keep broad-based price pressures under control despite a growing economy. That remains the case.

We expect Greenspan to comment that growth remains firmly entrenched and the outlook is positive, with a flexible economy that absorbed the large energy price shock of 2004. He will also suggest that inflation remains well contained, consistent with the earlier view of 1.5 - 2.0% core PCE deflator for Q4/Q4.

If there is a risk to Greenspan's testimony, it is that he leans to the hawkish side. That would be justified on the basis that market financial conditions remain quite easy. That is despite the 150bps in hikes by the FOMC since June 2004. For example, 10-year yields are currently 13bps lower than at the start of the year and 56bps lower than at end-May 2004 (on the eve of the first rate hike). In addition, the equity indices are higher, credit spreads are tighter, and the USD is weaker - all of which are working in the opposite direction of higher policy interest rates.

The other reasons Greenspan could be hawkish have been highlighted by us previously - there is inflationary pressure in the pipeline (for example in core intermediate producer prices) and the weaker USD may lead foreign firms to begin raising prices on their exports to the US.

While the risk is that Greenspan is more hawkish, we think that the probability is a low one. The reason is that he cannot micromanage market rates higher. If he were to highlight the current level of low market yields, the market reaction could push the curve strongly higher. More likely than not, Greenspan will continue with the recent script of the FOMC.

We have updated our Fed call slightly, expecting now three more 25bps increases - to 3.25% by end June - from our longstanding view of 3.0% fed funds by end-June. By the second half of the year, we see the economy slowing to reflect tighter fiscal and monetary policies. That should keep the Fed on hold through the end of the year.