FOMC: Preview of Policy Meeting

• On Wednesday, 29 April, at 20:15 CET the Federal Open Market Committee (FOMC) is set to announce its policy decision. In line with consensus, we expect the FOMC to keep the Fed Funds rate unchanged in the interval from 0.00-0.25%.
• Focus will be on the FOMC's decision on alternative easing measures. We do not expect a scale-up of current credit easing measures or the announcement of any new ones. The statement is nevertheless likely to keep the door open for scaled-up credit easing if it should become necessary further down the road. We expect the statement to remain biased towards fighting the financial crisis and deflation risks.
• We do not expect any big surprises from tomorrow's statement and hence no big market reaction. We generally prefer to be positioned for higher rates and steeper curves.

Activity: Incoming activity indicators have continued to be weak but there have been widespread signs that the pace of contraction is declining. In some areas such as consumer spending we have seen stabilisation and even the decline in home prices has taken a break. While this has most likely been a positive surprise to the FOMC, labour market developments have probably turned out at least as bad as expected. While a lot of stress remains in financial markets, there have also been signs of improvement here. Equities have performed better, money market spreads have declined and credit spreads have narrowed further. We thus expect the statement to acknowledge that both the economic outlook and financial markets have improved somewhat, but to highlight that labour market conditions continue to be weak and financial markets remain under pressure.

Inflation: Commodity prices have stabilised at a low level and both headline and core inflation is slowing. Surveyed inflation expectations have declined slightly, but are holding relatively stable. The statement is likely to reiterate that there are "risks that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term".

Bias: Recent comments from FOMC members, including Bernanke, have been more balanced between the Fed's commitment to fight the financial and economic crisis and the commitment to price stability on a longer-term horizon. Both Bernanke and vice chairman Kohn have addressed the implementation of exit strategies once the economy recovers. While we take this as a sign that the FOMC has become more convinced that a recovery will take place in the second half of this year, we believe that it is still too early to mention a possible scale-back of quantitative easing measures directly in the statement. We expect the statement to state that the main concern of the committee remains improving financial market conditions and fighting deflation risks.

Policy outlook: The recession has led to a huge output gap in the economy and the unemployment rate has spiked to a level way above the NAIRU. Applying standard Taylor rules would suggest that the Fed should keep interest rates on hold at least throughout 2010. We believe that the Fed could choose to move away from the zero bound before that, but rate hikes will be off the agenda until the economy has returned convincingly to trend growth and unemployment has peaked. The focus of attention is expected to remain on credit easing measures, as long as the banking sector and financial markets remain under severe pressure

FOMC key statements

Statement from March 17-18 meeting:

Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract. Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession. Although the near-term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve's balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of evolving financial and economic developments.

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; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

Key extracts from March 17-18 minutes:

Overall, most participants viewed downside risks as predominating in the near term, mainly owing to potential adverse feedback effects as reduced employment and production weighed on consumer spending and investment, and as the weakening economy boosted the prospective losses of financial institutions, leading to a further tightening of credit conditions. Looking beyond the very near term, a number of market forces and policies now in place were seen as eventually leading to economic recovery.

Participants saw little chance of a pickup in inflation over the near term, as rising unemployment and falling capacity utilization were holding down wages and prices and inflation expectations appeared subdued.

For the most part, participants viewed conditions in financial markets as little changed but remaining extraordinarily stressed.

Recent speeches from FOMC members:

Kohn April 20

On growth: These developments may be an early indication that conditions are falling into place for real GDP to decline at a slower rate in the second quarter and to stabilize later this year.

On inflation: On the one hand, we cannot rule out the possibility that adverse economic conditions will cause deeper cuts in prices, a greater softening in wages, and a steep decline in inflation expectations. Substantial declines in inflation would raise real interest rates, thereby restraining the recovery even more. Moreover, the risk that inflation could be lower will be exacerbated to the extent that economic activity falls short of the path that I have described. In these circumstances, the Federal Reserve would continue to look for ways to relieve financial pressures and encourage spending.

But my colleagues and I are acutely aware of the risk of higher inflation as the economic recovery gains speed. We are firmly committed to acting in a way that preserves price stability, and we believe we have the tools to absorb reserves and raise interest rates when needed. Moreover, we are working with the Treasury to introduce legislation that would enlarge our tool kit for moving away from the extraordinary degree of financial stimulus we have put in place when the time arrives.

Bernanke April 14

On inflation and exit strategies: Although inflation seems set to be low for a while, the time will come when the economy has begun to strengthen, financial markets are healing, and the demand for goods and services, which is currently very weak, begins to increase again. At that point, the liquidity that the Fed has put into the system could begin to pose an inflationary threat unless the FOMC acts to remove some of that liquidity and raise the federal funds rate. We have a number of effective tools that will allow us to drain excess liquidity and begin to raise rates at the appropriate time; that said, unwinding or scaling down some of our special lending programs will almost certainly have to be part of our strategy for reducing policy stimulus once the recovery is under way.

To be sure, decisions about when and how quickly to proceed will require a careful balancing of the risk of withdrawing support before the recovery is firmly established versus the risk of allowing inflation to rise above its preferred level in the medium term.

We are thinking carefully about these issues; indeed, they have occupied a significant portion of recent FOMC meetings. In addition, when the time comes, our ability to clearly communicate our policy goals and our assessment of the outlook will be crucial to minimizing public uncertainty about our policy decisions.

Recently we have seen tentative signs that the sharp decline in economic activity may be slowing, for example, in data on home sales, homebuilding, and consumer spending, including sales of new motor vehicles. A levelling out of economic activity is the first step toward recovery. To be sure, we will not have a sustainable recovery without a stabilization of our financial system and credit markets. We are making progress on that front as well, and the Federal Reserve is committed to working to restore financial stability as a necessary step toward full economic recovery.

Kohn April 18

Our work on the framework for exiting these programs is one indication that we are focused on maintaining price stability over time even as we concentrate for now on promoting economic recovery. Another such indication is our increased emphasis on defining the price stability goal more clearly. Already the FOMC has extended its forecast horizon to indicate where the Governors and Reserve Bank presidents would like to see inflation coming to rest over time. And we are continuing to discuss within the Committee whether an explicit numerical objective for inflation would be beneficial.

Danske Bank
http://www.danskebank.com/danskeresearch

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