US Federal Reserve policymakers will aim to quell this week speculation about an early exit from their massive stimulus effort even with the economy showing more signs of recovery, analysts say.
The Federal Open Market Committee (FOMC), which opens a two-day meeting Tuesday, is unlikely to make any change to its near-zero interest rate policy or its efforts to flood the financial system with money to restore credit flows.
“I think they are very much concerned about the prospects for recovery,” said Michael Gregory, economist at BMO Capital Markets.
“The tone of the Fed has been trying to counter the expectations building in the market” of moves toward a hike in rates or withdrawal of the stimulus described by some as “quantitative easing” to pump money into the financial system, Gregory said.
The federal funds rate has been in a record-low range of zero to 0.25 percent for the past year, and the central bank is in the midst of a program injecting more than a trillion dollars into the system, mainly through the purchase of various government and agency bonds.
Bernanke tries to quash rumours
Fed chairman Ben Bernanke last Monday went out of his way to quash the notion that the Fed was closer to rate hikes in view of better economic news, especially in the labor market.
“Though we have begun to see some improvement in economic activity, we still have some way to go before we can be assured that the recovery will be self-sustaining,” Bernanke said in a speech.
Bernanke said the recovery faces “some formidable headwinds,” particularly the weak jobs market and tight credit conditions.
Markets will be watching to see if the Fed keeps language indicating rates would be held low for an “extended period.” Any significant change could signal the exit strategy is underway.
“We expect the ‘extended period’ language to be retained, reflecting the view that low resource utilisation, subdued inflation and stable inflation expectations should allow the FOMC to keep rates low in the coming months,” said Kerri Maddock at Barclays Capital.
“We look for only modest updates elsewhere, reflecting reflect better labor market data and some improvement in financial markets.”
Still, the Fed has acknowledged fine-tuning an exit strategy from this ultra-loose policy even if it is not ready to act, and the question for many analysts is when a shift will occur.
The central bank has begun market tests of reverse repurchase agreements that would remove some of the money pumped into the financial system.
Analysts: Shift likely in 2010
Morgan Stanley economists Richard Berner and David Greenlaw said the Fed is likely to start a shift in 2010, first by pulling back some of its liquidity measures and then by acting on rates, probably in the third quarter.
“The Fed will begin the gradual exit from its ultra-accommodative monetary stance in 2010,” they said in a note to clients.
“With growth risks tilting from balanced to somewhat higher, the rising rate scenario may unfold sooner rather than later.”
For the coming meeting, Berner and Greenlaw say officials “likely will acknowledge the improvement in the economy, but probably will make only minor changes to the language in the statement following the meeting.”
But assuming the economy continues to grow, they said “we expect rate hikes will start in the third quarter, with the policy rate going to 1.5 percent by year-end and to 2.0 percent in 2011.”
Financial markets however have moved to price in the possibility of rate hikes coming even sooner. The dollar has been rallying and bond yields rising.
“The improvement in US retail sales, higher import inflation and consumer sentiment may revive speculation of an earlier Fed rate hike and boost demand for the dollar,” said Michael Malpede, analyst at Easy Forex.
Malpede said recent economic reports have begun to “fuel speculation the Fed may begin to raise interest rates early next year.”