August 10, 2010 Unusual uncertainty clouds Fed meeting
WASHINGTON (MarketWatch) -- Federal Reserve officials started their meeting Tuesday amid unusual uncertainty about what steps they might take in response to the downshift in economic growth over the past two months.
The Fed meeting began at the unusual hour of 8 a.m. Eastern because it is a one-day meeting, officials said. A policy statement is expected to be released at about 2:15 p.m.
In late July, Federal Reserve Chairman Ben Bernanke went before Congress and said that Fed officials were having trouble figuring out where the economy was headed. While the Fed was preparing for an exit strategy from its easy monetary policy, "we also recognize that the economic outlook remains unusually uncertain," Bernanke said at the time.
Now, economists are having trouble figuring out what the Fed wants to do, given that the starting point is a near-zero federal funds rate target and a $2.3 trillion balance sheet.
Former Fed governor Laurence Meyer told clients that he believed the Fed would stop short of taking any easing steps, but then went on to say he wouldn't be surprised if the central bankers took a baby step or two.
"You might say you detect more uncertainty than usual in our call about what will happen at the upcoming meeting," Meyer wrote in a note to clients. "But if we shared this angst with [Fed] committee members, they would surely say: 'Get in line.'"
Debate over action plan
The big question is whether the Fed feels it must take immediate action in light of the recent disappointing data.
Economists are split on the issue. Many view the recent data as weak, but not overly so, pointing out the Fed has already stressed that the recovery would be moderate.
This camp believes the Fed will discuss the grimmer outlook in its statement, but not pull the trigger on any easing move, either symbolic or substantial.
The Fed will not present formal changes to its forecasts until its meeting in early November.
"We think it is a little too soon for the Fed to signal a shift in policy," said the economic team at Bank of America/Merrill Lynch.
Baby steps would only increase the market's thirst for more easing, the B. of A. team said.
"Hence before taking the first step, the Fed wants to feel comfortable that it is ready to move quickly to the second step. We don't think the mild slowing thus far is enough to push them down the slippery slope," the note said.
Other economists don't believe the options would work. The problem with the economy is a lack of demand -- not low interest rates, they note.
Assortment of options
Many Fed watchers expect the Fed to take some concrete steps to demonstrate its concern about the outlook. No action might cause a selloff in financial markets, they noted.
David Resler, chief economist at Nomura Securities, said the Fed will take a "shot across the bow" by reinvesting its maturing housing-related assets so its balance sheet doesn't shrink.
The move "would remind investors that the Fed has many tools available to fight deflation, and that it is willing to use them if needed to meet its full employment and price stability objectives," Resler wrote in a research note.
Economists at MF Global said reinvesting proceeds of maturing mortgage-backed securities would be "a largely token easing."
Economists at RBC Capital Markets said the odds of another round of asset purchases have grown significantly, but the Fed won't announce it this time around. "This would smack of desperation in our view," they said.
Dean Maki, chief economist at Barclays Capital, said the FOMC would focus on contingency planning, but it is "premature for it to implement such plans now."
"If the Fed were to move to additional stimulus measures next week, it would be a clear signal that it had lost confidence in its forecast; we do not think that recent data have been so weak to warrant such an abrupt change in the Fed's views," Maki wrote.
In his testimony to Congress, Bernanke listed three options the Fed would consider if the outlook were to worsen appreciably: alter the language of its "extended period" language commitment; trim the interest rate paid on excess reserves from a quarter of 1 percentage point to zero; or end the runoff of its balance sheet.
The chairman noted that the Fed had not reached the point where one of the options was a leading one.
Other ideas are also floating around. Some economists think the Fed could set a temporary inflation target of 4%.
Fed watchers are also interested to see whether Thomas Hoenig, president of the Kansas City Federal Reserve Bank, will dissent once again from the Fed's "extended period" language. Hoenig has dissented at every meeting this year.
James Bullard, president of the St. Louis Fed Bank, caused a stir when he said the U.S. economy was close to a Japanese-style deflation episode. Bullard wants the Fed to get rid of the "extended period" pledge but promise to take action to offset deflationary threats.
Most economists do not view deflation as a near-term risk.
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