FOMC: Preview of Policy Meeting

Overview: On Wednesday night this week at 19:15 CET the Federal Open Market Committee (FOMC) is set to announce its policy rate decision. In line with market expectations and analyst consensus, we expect the Fed to keep the 0-0.25% range on the Fed funds target in place. The focus of attention will be on the committee’s stance on credit easing. Spreads between MBS and Treasury yields have narrowed slightly since the last Fed meeting, but mortgage lending rates have stabilised above 5%. Pushing mortgage rates further down would require either increasing the size of the MBS and agency purchase programme or buying up Treasuries. We believe that the Fed will stick to the first option for a number of reasons. First, Bernanke has explicitly said that Fed interventions are targeted at "severely disrupted markets" which is not the case for the Treasury market. Second, substantially expanding the MBS programme would also help to bring down Treasury rates as investors engage in duration and convexity hedging. Third, scaling up MBS and agency purchases have been mentioned in numerous speeches recently. Nevertheless, we believe that the Fed will continue to emphasise that Treasury purchases remain an option going forward. In combination, such an announcement could spark a rally in long-dated Treasuries and we prefer reducing positions that are short duration and long steepening heading into the meeting.

Activity: In the inter-meeting period, incoming activity data have continued to be weak, although there have been glimmers of light in retail sales and a stabilisation in the ISM index, albeit at a very depressed level. Turning to the labour market developments have probably turned out even worse than the already downbeat expectations at the committee. Financial market conditions have remained very tight following some improvement before the last meeting. The committee is expected to acknowledge the sharp deterioration in the labour market and present a continued very negative outlook. The contraction is expected to be described as broadly-based and financial markets as remaining under pressure.

Inflation: Commodity prices have stabilised at a very low level and both headline and core inflation is slowing. Surveyed inflation expectations have declined slightly, while TIPS inflation expectations have held stable. The statement will underline that the committee’s main concern remains deflation risks. Hence, the phrase that "risk inflation could persist for a time below rates that best foster economic growth and price stability in the longer term" is likely to be reiterated.

Bias: Recent communications from Fed chairman Bernanke and other prominent Fed governors suggest that the Federal Reserve is ready to take further steps to mitigate the financial and economic crisis. We expect the forward-looking part of the statement to restate that the funds rate will remain low for a considerable period. On top of the announcement of an immediate expansion of the MBS programme we expect the statement to say that other existing credit easing measures could be expanded as well and that new programmes, such as purchases of Treasury securities, will be implemented if necessary.

Policy outlook: The Fed is expected to keep rates on hold for a long time and the focus of attention is ex-pected to remain on credit easing measures, as long as the banking sector and financial markets remain under severe pressure. On top of the implementation of existing initiatives, new measures could include fur-ther intervention in credit markets or alternatively the Treasury market. Hikes will not be on the agenda be-fore the economy has returned to trend growth and unemployment has peaked.

Statement from the January 27-28 meeting:

"The Federal Open Market Committee decided today to keep its target range for the federal funds rate at 0-1/4%. The Commit-tee continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

Information received since the Committee met in December suggests that the economy has weakened further. Industrial pro-duction, housing starts, and employment have continued to decline steeply, as consumers and businesses have cut back spending. Furthermore, global demand appears to be slowing significantly. Conditions in some financial markets have im-proved, in part reflecting government efforts to provide liquidity and strengthen financial institutions; nevertheless, credit con-ditions for households and firms remain extremely tight. The Committee anticipates that a gradual recovery in economic activ-ity will begin later this year, but the downside risks to that outlook are significant.

In light of the declines in the prices of energy and other commodities in recent months and the prospects for considerable eco-nomic slack, the Committee expects that inflation pressures will remain subdued in coming quarters. Moreover, the Commit-tee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. The focus of the Committee's policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve's balance sheet at a high level. The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets. The Federal Reserve will be implementing the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Committee will continue to monitor carefully the size and composition of the Federal Reserve's balance sheet in light of evolving financial market developments and to assess whether expansions of or modifications to lending facilities would serve to further support credit markets and economic activity and help to preserve price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Dennis P. Lockhart; Kevin M. Warsh; and Janet L. Yellen. Voting against was Jeffrey M. Lacker, who preferred to expand the monetary base at this time by purchasing U.S. Treasury securities rather than through targeted credit programs."

Key statements from January 27-28 minutes:

"Participants agreed that inflation pressures had diminished appreciably in recent quarters, and they expected significantly lower headline and core inflation during the next few years than during recent years. Indeed, most anticipated that inflation will slow for a time to rates somewhat lower than those they judge consistent with the dual goals of price stability and maximum employment, initially reflecting the recent declines in the prices of energy and other commodities and later responding to sev-eral years of substantial economic slack. Many participants noted some risk of a protracted period of excessively low inflation, especially if inflation expectations were to move down in response to lower actual inflation and increasing economic slack, and a few even saw some risk of deflation"

"Several participants indicated that they thought the FOMC should explore establishing quantitative guidelines or targets for a monetary aggregate, perhaps the growth rate of the monetary base or M2; in their view such guidelines would provide useful information to the public and help anchor inflation expectations."

"Participants were, however, quite uncertain about the outlook. All but a few saw the risks to growth as tilted to the downside; in light of financial stresses and tight credit conditions; they saw a significant risk that the economic recovery would be both delayed and initially quite weak. In particular, most participants saw the renewed deterioration in the banking sector’s financial condition as posing a significant downside risk to the economic out look absent additional initiatives to stabilise the banking system."

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