This is a very important week in the financial market because we finally have an opportunity to get into the minds of the Federal Reserve. With everyone from economists to investors and even central bankers divided on whether a third round of stimulus or QE3 will become a reality, the heavy U.S. economic calendar and Ben Bernankeâ€™s semi-annual testimony could reshape the marketâ€™s expectations and with it, the trend of the U.S. dollar. This is a week where volatility in the foreign exchange market could soar if there are any surprises in U.S. data or in Bernankeâ€™s testimony.
However while we will be watching every data release closely and listening to each word that Bernanke utters, in reality thereâ€™s a much greater chance for confusion than clarity this week. There is no question that the Federal Reserve is pessimistic about the outlook for the U.S. economy, but there is just not enough consensus within the monetary policy committee for the central bank to say yes to QE3 in August. The next Federal Reserve monetary policy meeting is only 2.5 weeks away and while the labor market is weak, last monthâ€™s non-farm payrolls report was not bad enough to make QE3 a done deal.
Instead, September is a far more realistic time for QE3 because by then 2 additional months of non-farm payroll reports will be released, central bank officials would have held their annual economic summit in Jackson Hole and the Fed would have prepared their latest economic projections. QE3 is a very big decision because Quantitative Easing is not only one of the central bankâ€™s most powerful monetary policy tools but also one that is wrapped in political controversy. As a result, it will not be a decision that is made lightly by Federal Reserve officials and they can certainly use the 2 additional months to make sure that QE3 is absolutely necessary. The Fed will also need to conduct a thorough analysis of the U.S. economy for their September economic projections and the monetary policy committee members will want to wait for this report to be completed before making their decision.
At the same time, whenever there is a major change in monetary policy that could send financial markets reeling, central bank officials like to prepare the market for the change so that when it comes, there will be less volatility. The Jackson Hole Summit would be the perfect opportunity to signal a big monetary policy announcement and it has been a venue of choice for Bernanke in the past. In 2011, Bernanke announced at Jackson Hole that the September FOMC meeting would be expanded from 1 day to 2 days, giving the central bank enough time to outline the details for Operation Twist, which was launched that month. In 2010, Bernanke delivered an infamous speech tipping off the market that QE2 was on the way.
The Fed Chairman is also scheduled to deliver a press conference after the September FOMC meeting, which would be the perfect opportunity for him to take questions and clarify any decisions made. With opportunities to prepare the market for QE3 in late August and to explain it in further detail after the meeting in September, it is far more realistic for the Fed to increase their asset purchases in 2 months than in 2 weeks.
Therefore we donâ€™t expect Bernanke to drop any hints about monetary policy this week. Given his recent comments, we know that he is among the more dovish members of the central bank and has a pessimistic outlook for the U.S. economy. This sentiment will remain unchanged but that may not be enough to satisfy traders banking on QE3 in August. If Bernanke is pessimistic but noncommittal about QE3, the U.S. dollar could rally but once the dust settles, the rally should turn into consolidation because at the end of the day, the Fed is still keeping the market guessing.