. The

Federal Reserve

Open Market Committee is holding a two-day meeting this week, with the outcome anticipated near 2:15 p.m. EST on Wednesday, Jan. 28. There is little doubt that the fed funds target of 0 to 25 basis points will be retained. That accompanying statement will receive the market's full attention.


. The data since the mid-December FOMC meeting have been dreadful, and this poor environment will prevent a substantive change in the Fed's assessment. Labor market conditions have continued to deteriorate. Consumer spending, business investment and industrial production figures are poor. The outlook for continued weakening of economic activity will be retained.


. Inflationary pressures continue to diminish. In December, the FOMC said that it expected inflation to moderate further in coming quarters. Although most measures of price pressures have moderated, inflation expectations appear to have stopped falling. Consider that at the conclusion of the FOMC meeting on Dec. 16, the five-year/five-year forward, which Fed officials (and ECB officials) have cited as a measure of inflation expectations, implied an expected inflation rate of about 60 basis points. On the eve of this week's FOMC meeting, it is near 150 basis points.


. In December, the FOMC reiterated its intentions to utilize other measures to stimulate the economy, such as its purchases of agency debt and mortgage-backed securities. It also said it was evaluating the possibility of buying long-dated Treasury securities.

The market is looking for at least an update on this point. Treasuries initially rallied on the news, but yields have backed up since the start of the month and 10- and 30-year Treasury yields are now near their highest levels since the last FOMC meeting.


. Fed officials have been particularly circumspect in terms of specifics about what maturities for Treasuries they were thinking about buying, though the three- to six-year sector has been suggested. The market is well aware, though, that from late 2002 through mid-2003, Ben Bernanke as a Fed governor suggested increased outright purchases of long-dated Treasuries, and nothing ever transpired. This prompts some concern that if the Fed does not buy Treasuries, it loses some credibility and erodes confidence, and if it


buy Treasuries, it risks disrupting the market amid talk from some large institutional investors that the U.S. government debt market is already showing some characteristics of a bubble.


. There has also been some discussion of the Federal Reserve adopting a formal inflation target. Bernanke has long supported the idea, but he faced opposition among some of the governors, including from Vice Chairman Donald Kohn. However, as a tool to combat deflation expectations, a formal inflation target is thought to be potentially helpful. Nevertheless, it seems too early for the Fed to announce one, and it would likely not be announced at an FOMC meeting.


. With the Fed rate near zero and the Federal Reserve relying on extraordinary measures to support the economy and financial markets, the role of the regional presidents has been diminished. This is prompting some consternation by several regional presidents.

The institutional arrangement between the Board of Governors and the regional presidents took several decades to evolve, and this crisis is threatening that that modus vivendi. This tension is below the surface and not much of a market factor at the moment, but it does suggest that after the crisis is over, there may be scope for some institutional reforms at the Federal Reserve itself.


. The differences between the Federal Reserve and the European Central Bank are significantly greater than most market participants appear to appreciate. Most of the contrasts have focused on aspects that I suspect are more superficial than material. Some observers have overemphasized the fact that the Fed looks at core inflation and the ECB focuses on headline inflation. Yet the Fed looks at several measures of inflation and inflation expectations, some of which do look at headline rates, such as the Treasury's inflation-protected securities (TIPS). Some observers have overplayed the significance of the ECB's formal inflation target. Fed officials have talked about their "comfort zone" for inflation, which is like an informal target, while the ECB has consistently missed its formal target, making it more like an informal target.


. Still, key differences exist between the Federal Reserve and ECB. In terms of structure, the Federal Reserve has a large central board and a relatively weak voice for the regional Fed presidents. In contrast, the ECB has a weaker central board and an apparently larger role for the national central bank governors.

The bigger difference was hinted by ECB member and Luxembourg central bank governor Yves Mersch: The ECB may not have the policy levers at its disposal to engage in quantitative easing. If it were to buy bonds with newly printed euros, whose bonds would it buy and how would the decision be made? There are no European assets, only national assets. This is one institutional consequence of having monetary union without political union.

Simply put, under the current interpretation of its charters, the ECB may not have the tools at its disposal to explore the unconventional policy prescriptions that other central banks (including the Federal Reserve, Bank of England and Bank of Japan) are either considering or executing.


. Countries like the U.S., U.K. and Japan have a distinct advantage over eurozone members insofar as the former are currency issuers in a way Germany, France, Italy, Ireland and Spain, for example, are not. Therein lies the rub. While the long-term inflationary implications of quantitative easing can be debated (though it is interesting to note that they have not materialized in Japan), those are second-order issues -- inability or significant obstacles for the ECB may prevent it from addressing first-order issues.

This gap, combined with the dramatic widening of interest spreads with the eurozone and talks of a breakup (which I believe is neither imminent nor inevitable), underscores my belief that talk of the euro replacing the dollar as the world's chief reserve asset is grossly exaggerated. I continue to believe that multiyear bull market for the euro is over and that the euro returning to its birth rate in the high teens is the most likely scenario.

Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback;

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