Gradual Recovery Is Coming: The Fed Keeps Policies Unchanged But Upgrades Outlooks

The June FOMC meeting ended largely inline with our forecasts though the Fed's outlook on inflation seemed to be more hawkish than what we anticipated. On the whole, the Fed kept the target range for the federal funds rate at 0 - 0.25% and maintained the current asset purchase program of $1.75 trillion.

Apart from announcing the keep interest rates unchanged since the last reduction in December, the Fed also stated that current market conditions warranted 'exceptionally low levels' of interest rates for an 'extended period'. This was done particularly to halt recent speculations that a rate hike may come later this year. Bets on a rate hike by December reduced to 33% as shown by CBOT's Fed funds futures after the announcement, compared with as much as 75% at the beginning of the month.

As widely anticipated, the Fed made no change on the size of the $1.75 trillion asset purchase program. However, what surprised us was that the compositions of the purchases were also unchanged. Such decision may indicate the policymakers were contented with the progress and outcomes of credit easing so far. On the other hand, it may reflect that some policymakers were averse to buying Treasury further as the Fed has been questioned about its independence.

Concerning recent economic development and outlook, policymakers believed that information received since the meeting in April that 'the pace of economic contraction is slowing. Conditions in financial markets have generally improved in recent months. Household spending has shown further signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit'. The Fed's concern about deflation was obviously reduced. In the accompanying statement, the Fed only mentioned that 'inflation will remain subdued for some time', and dropped 'inflation could persist for a time below rates that best foster economic growth and price stability in the longer term' which appeared in April.

The Fed upgraded its 2H09 growth forecasts and lowered the probability of deflation. Details will be released in the FOMC minutes on July 15. We believe the upward revision hinged on the less pessimistic outlook on deflation.

While keeping all policy measures unchanged this time, the Fed did try to give policymakers flexibility to make adjustment should economic and financial conditions warrant. The last sentence of the statement said that the Fed is 'monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted', suggesting changes in the size and compositions of the asset buying program are still possible, depending on evolution of economic conditions.

The bond market plunged after the Fed decided not to extend the current asset purchase program. 10-year yield edges higher to 3.7% in Asian session after rising 6 bps, the largest increase since June 18, yesterday, as the market concerned that the ample supply will not be adequately absorbed. The dollar has mild pullback today after rallying +1.1% to 1.393 against the Euro after the Fed statement yesterday