April 27, 2009 / 9:03 PM / 11 years ago

What the Fed is considering at this week's meeting

CHICAGO (Reuters) - The Federal Reserve meets this week at a time when the U.S. economy has shown some signs of improvement, and the central bank is likely to restate its support for boosting the economy through both conventional and unorthodox means.

Morning commuters drive past the Federal Reserve Bank building in Washington March 18, 2009. REUTERS/Jonathan Ernst

Economists expect the U.S. central bank to hold its target range for its benchmark federal funds rate steady at zero to 0.25 percent, as it has since December, and to indicate again that it will keep interest rates low for some time.

In fact, many analysts suggest that the Fed will not raise the funds rate until anywhere from 2010 to 2012, even if other, alternative stimulus measures can be wound down sooner.

“Nothing is expected to come out of this meeting after the bombshell announcement of buying Treasuries at the last meeting,” said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi in New York.

The U.S. economy remains in a severe contraction, but signs are emerging that the pace of rate of decline has slowed.

Analysts said the Fed will attempt to tread carefully between acknowledging a slight improvement in economic conditions and the risk of pushing up longer-term inflation expectations and long-term bond yields.

“In the event that the FOMC statement makes a discreet reference to improved market/economic dynamics ... bond yields could easily snap back up,” said Ashraf Laidi, chief market analyst at CMC Markets in New York.

The Fed is expected to issue its policy statement around 2:15 p.m. EDT on Wednesday.

Following are some of the factors policy-makers are considering:

ECONOMY

Policy-makers are likely to focus on whether signs of life seen in the economy in February are a sign that the worst is over for a severe recession that started in December 2007, or just the prelude to another decline.

The first-quarter advance GDP report will be published on Wednesday, the second day of the FOMC meeting. Estimates range widely around a median of a 4.9 percent rate of contraction on an annualized basis, compared to a 6.3 percent fall in output in the fourth quarter of 2008.

Among the economic elements that have shown stabilization recently are retail sales, housing starts, capital goods orders and net exports.

For example, sales of new homes held nearly steady in March, and the year-to-year decline of 30.6 percent in sales was much smaller than levels seen over the past six months. Unit auto sales also rose in March from February.

Still, employment remains a sore point. The U.S. jobless rate is forecast to have risen to 8.8 percent from 8.5 percent in April, a month when the economy probably shed another 630,000 jobs. Many economists and some Fed officials expect the jobless rate to hit 10 percent this year.

“Guarded optimism is the most likely opinion that will surface in the policy statement,” said Asha Bangalore, economist at Northern Trust in Chicago.

The output gap created by the shrinking job market should keep the Fed focused on deflationary forces, for now.

But policy-makers, from Chairman Ben Bernanke on down, have been clear they are planning their exit strategy from the various liquidity programs, and will act to prevent inflation taking hold as the economy recovers.

FINANCIALS

Several measures of financial market stability have also improved since the March FOMC meeting, suggesting that the vicious cycle between damaged financial markets and the weak economy might finally be ending.

Major stock market indexes are up about 5.0 percent since the March FOMC meeting, with financial shares outperforming, and the VIX volatility index, often known as the market’s “fear gauge,” is lower.

Credit market conditions are also more encouraging. The spread between risky securities and less risky securities has narrowed, suggesting risk aversion is slowly fading from the extremes seen in September and October 2008.

The LIBOR/OIS spread, an indicator of the relative availability of funds, has been stable for most of 2009, although it remains far above levels seen before financial turmoil erupted in 2007.

UNCONVENTIONAL TOOLS

The Fed surprised many market participants in March by confirming it would buy longer-term Treasury debt.

This time around, policy-makers will probably refrain from new announcements but restate their commitment to using “all available tools” to promote an economic recovery.

The Fed’s purchases of mortgage backed securities have been credited with helping to drive down mortgage rates and starting to kindle a recovery in the housing market.

The Treasury Asset-Backed Securities Loan Facility (TALF) is still in the early stages of trying to push credit to households and small businesses.

“The FOMC’s main effort will be to keep plugging away at these programs, which in the case of the TALF may involve more tweaking of the terms, as has been done lately,” said Goldman Sachs economist Ed McKelvey.

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