Previewing Today's 12:30 EDT FOMC Decision, And The Fed's Options Should The Economy Not Rebound
Just like yesterday's G-Pap vote of confidence was largely a snoozer and a "sell the news" type of event, so today's FOMC meeting and subsequent press conference, will likely disappoint, despite the 2 Year now trading at an Operation Twist 2 "priced in" 0.358%. It is certain that this expectations of at least some modest Fed intervention has slipped into equities. Thus, should Gross' prediction of a tentative QE3 announcement today fall through, and remember that the S&P has to be about 20% lower for the green light in our humble opinion, look for Waddell and Reed to be put under quarantine again at 12:30 when the decision is released.
Here is what one can expect from the FOMC in 5 hours, courtesy of Ran Squawk:
FOMC rate-decision due at 1230 EDT followed by Fed’s Bernanke press-conference at 1415 EDT
It is expected that owing to recent weakness in US economic data, alongside adverse external factors such as the ongoing Eurozone debt concerns, Japanese earthquake and nuclear crisis and tension in the MENA region, the Fed will refrain from any monetary tightening for the time being. At the same time, the central bank is unlikely to opt for another round of Treasury and TIPS purchases as the ongoing debate over the issue of the US debt ceiling together with recent rating agency concerns surrounding country’s ballooning deficit are likely to prove a further deterrent to “QE3”.
In the accompanying press conference, Bernanke is expected to reiterate that the FOMC seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. He is also expected to support the policy of reinvesting principal payments from agency debt and mortgage-backed securities in longer-term Treasury securities. This would ensure the total face value of domestic securities held in its System Open Market Account (SOMA) is at approximately USD 2.6trl. The Fed will likely keep the fed fund target unchanged in the range of 0%-0.25%, and the chairman may note a disappointing non-farm payroll figures for the month of May, which saw an addition of a meagre 54K jobs to the economy. However, Bernanke is likely to emphasise that the recent weakness is temporary in nature and will dissipate in due course.
Although the Fed is unlikely to change its medium to long term growth and inflation forecasts, it may downgrade its 2011 real GDP forecast, citing a weak first quarter. It is worth noting that the Fed downgraded its real GDP 2011 forecast in April to 3.1%-3.3%, from its previous January projection of 3.4%-3.9%. On the inflation front, the Fed is expected to reiterate that it will pay close attention to the evolution of inflation and inflation expectations, however it may say that any rise in inflation would be transitory, citing the recent downturn in commodity prices. It is also expected that the central bank will keep the “exceptionally low for an extended period” phrase in its June statement.
Markets will also keep a close eye on any comments with respect to the discount window, which currently stands in the range 0%-1.25%. To bolster growth, the Fed may decide to reduce the primary or secondary credit rate from its current 0.75% and 1.25% levels respectively. Alternatively, it may expand the range of collateral it accepts to more riskier assets, thus helping the wider economy and at the same time lowering rates on these assets. A less likely, yet conceivable area to watch for would be any potential comments on setting a higher inflation target, which in turn would accentuate Fed’s “extended period” language.
Overall the Fed is likely to be in “a wait and see” mode and as such the reaction may be a muted. However, in the unlikely scenario that the Fed does opt for “QE3”, it would come as a big surprise to the market and given historic reaction to an increase in quantitative easing the USD would likely come under heavy selling pressure where as stocks may benefit from the Fed’s intention to continue its support for the economy.
And from Bloomberg's Senior Economist, Robert Elson:
Fed Options If Economy Does Not Rebound
• Fed will acknowledge slowing growth, slightly altering statement to reflect a “recovery that is proceeding at a modest pace.”
• Committee will likely point to falling commodity costs, anchored inflation expectations and labor market slack as trumping transitory bump in inflation.
• Central tendency forecast for 2011 will likely see growth forecast shaved down to 2.75%, or roughly 1% below where Fed started out the year and downward revision to 2012 forecast.
• Questions in presser are likely to revolve around what arrows the Fed has left it its quiver to support the economy should it not rebound.
At its two-day meeting the FOMC will likely discuss what steps to take, if any, to support the economy and financial markets following the culmination of its asset purchase program.
While those options are dwindling, the Fed has at its disposal a series of potent measures that it can implement in the unlikely event that growth slows further in the second half or slows unexpectedly in 2012.
Given that the Fed President Ben Bernanke has gone out of his way to state that a near term resumption of asset purchases is unlikely and the hurdle to quantitative easing III is quite high (Please see the June 10 Bloomberg Economic Brief), the Fed can turn to other alternative measures to support the economy if necessary.
Thus, it would not be surprising if one of the first questions in today’s FOMC press conference is what the Fed is ready to do other than another round of asset purchases to support the economy.
Bernanke is likely to state that the central bank has at its command a set of tools that will permit it to support financial markets and economic activity, that do not all rely on asset purchases.
Mostly, they have to do with what the Fed refers to as its communications policy, or its ability to influence the direction of the short and long-term interest rates, financial conditions, and economic activity and inflation expectations.
With the federal funds rate essentially at zero, the central bank can only indirectly influence the level of long-term yields either through asset purchases or committing to remain accommodative for a much longer period of time than is currently expected.
Under traditional monetary conditions, the transmission mechanism starts with the changes in the overnight rate. Under current conditions, the transmission mechanism of begins with attempts to alter the level of long-term rates.
To keep long term yields low, absent further asset purchase, any Fed move to support the economy can best be classified as conditional commitment, formal commitment and going nuclear.
First, the FOMC can conditionally commit to keeping the current policy path for a specific period of time based on the evolution of economic conditions. The Bank of Canada did exactly that from April 2009 to April 2010 when it kept its policy rate at 0.25 percent.
In one sense, the Fed has implicitly done so over the past 18 meetings (2 years, 3 months). Thus, maintaining the phrase “extended period of time” in the statement, and making that commitment more explicit would likely not dislodge long term inflation expectations which currently stand at 2.1 percent, nor cause an upset in financial markets.
A conditional commitment that acknowledges the need to remain on hold until a specific point in the future when the Fed expects the economy will be able to stand on its own, would signal to investors that policy will remain accommodative even as growth and employment modestly rebound.
Along those same lines, the committee could choose to maintain its balance sheet at or near current levels to support lower long and short term yields, to facilitate growth.
Alternatively, The Fed can simply reduce interest paid on reserves to zero to from the current 25 basis points to spur bank lending at low current rates by eliminating the return on excess reserves of the banks at the Fed.
Second, as suggested by a recent Bloomberg news report, the Fed could make explicit its implied inflation target of 2 percent to firmly anchor public expectations of prices if the committee chooses to formally commit to supporting the economy for a longer period than is currently anticipated.
Given the increase in core PCE and CPI over the past few months even with the generous amount of economic slack that remains in the economy, the FOMC could turn to a formal targeting regime to bolster market confidence and buttress its own credibility in light of risks to the outlook from inflation.
Third, should these measures not translate into better employment and growth or deflationary risks return, the Fed could go nuclear. In his 2002 speech “Deflation: Making Sure it Doesn’t Happen Here” Bernanke did make a credible case for capping yields as a method of addressing deflation with interest rates at the zero bound.
Finally, should banks not respond to the incentive of a zero return on holding excess reserves at the Fed, policymakers could impose a penalty on excess reserves essentially taxing banks that choose to park money at the Fed.
While the nuclear option remains an outlier, should the economy prove it is not ready to stand on its own, the committee will likely consider alternative scenarios to support growth and it will be interesting to see if Bernanke provides any hint of conditional or formal commitment in his answers to questions in today’s press conference.
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