Ahead of the FOMC meeting: The Fed’s balancing act

Remember that thing my barber told about the times… I mentioned it in one of my recent posts… you know… that thing about the current situation… He said, “These are unprecedented times – we just don’t know what’s going to happen.”

Well, we have a major event coming up today at 6:15 pm GMT – the Federal Open Market Committee (FOMC) of the US Federal Reserve will be releasing its funds rate decision. With rates as low as they can get , the FOMC is expected to maintain its target interest at 0.25% which has been cut from a high of 3.5% during the start of 2008 in an effort to boost the economy out of the recession. Everyone seems to know what will happen… but given the current situation, we can never really tell…

There have been some remote speculations that the Fed may hike its interest rates because of the recent improvements in the economy and the threat of high inflation given the US’ surging budget deficit. Some of these concerns also surfaced during the recent G8 meetings, where officials met and mentioned that central banks and governments should start thinking of exit strategies… One has to ask, “Is it actually time to start thinking of exit strategies?”

Let’s take a look at what’s happening right now. While the US economy has been showing signs of improvement, labor conditions continue to be weak. Continuing jobless claims rose to an all time high of 6.69 million in the week ending June 6. Recently, President Obama said that he expects the US unemployment rate to jump from 9.4 this May to 10% by the end of this year. On the fiscal side, the nation’s budget deficit for 2009 is expected to reach $1.85 trillion – which is equal to about 13% of its GDP!

As you can see, the US government has been spending huge amounts of money to help curb the recession. What then, would an increase in interest rates do? Any suggestion of a rate hike, which would combat inflation, would hinder economic recovery. Rising inflation doesn’t appear to be a threat as of right now anyway. Recent reports have shown that consumer and producer prices are showing slower growth.

Another potential move that is a hot topic among central banks today is quantitative easing. Just the mere hint of the Fed expanding its quantitative easing measures still creates quite a hefty impact on the foreign exchange market. Last April, when the Fed first mentioned quantitative easing measures, the EURUSD pair fell by over 300 pips! The Federal Reserve has already pumped in a whopping 1.75 trillion dollars into the economy in order to loosen tight credit conditions and try to stimulate economic growth.

Considering how much the Fed has already spent on government treasury bonds, the prospect of another expansion of monetary policy is… well… a long shot. At the same time, with the economy still showing some struggle, we probably shouldn’t expect a pullback on Treasury purchasing by the Fed. The Fed probably still feels that the full effects of the program have yet to be seen. At least that’s what all these analysts, economists and experts are saying…. This may very well be the case but don’t discount the possibility just yet…

All these “positive” economic data here and there has caused long-term interest rates to rise. Just last week, we saw 10-year US Treasury yields increase by 0.70% pushing interest rates on 30-year mortgages by the same amount. What’s the Fed to do now? Expand its treasury bonds purchasing once again to lower long-term interest rates?!? A move like this is way too early on a “recovering” economy. The country’s economic health may have improved somewhat but it certainly isn’t at all stable as pointed out earlier. If this persists, the sudden rise in long-term interest rates in a time like this could possibly cut economic recovery short and once again worsen housing market conditions.

Well, the Fed certainly has a lot on its plate right now. Upward revisions of growth forecasts… Talks of exit strategies… Interest rate hikes… Expansion of quantitative easing… Too much too soon, don’t you think?

The Fed could wait until its next meeting in August before bouncing back to being the cheerleader of the economy in making upbeat revisions of its growth forecasts. Of course this depends on whether key economic indicators, such as employment, manufacturing activity, home sales, and consumer spending, show some spirit in the next few months.

The next FOMC meeting still seems a tad too early to be implementing exit strategies from the Fed’s quantitative easing efforts, especially since the full capacity of the program has not yet been reached. Also, interest rates are expected to be on hold for a prolonged period until inflationary pressures are no longer feeble. The economy has yet to make that convincing shift from stabilization mode to recovery mode before the Fed becomes all rah-rah-rah about economic growth all over again.

As of now, traders seemed to have already positioned themselves in anticipation for today’s FOMC statement. Yesterday, we saw the dollar fall on increased risk appetite, presumably on the notion that the FOMC wouldn’t be cutting rates. Traders will probably expect the FOMC to take note of improvements in some areas of the economy, but still remain cautious over the economy. Unless the FOMC drastically upgrades or downgrades their assessment, or has a surprise rate decision or quantitative easing expansion, then we may not see the market react too much to the FOMC statement. “Better to be safe than sorry,” wise words from my barber again… Be careful when trading around the time of the release!