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FOMC Preview: What to look for

By Neil Irwin

For the first time in months, it is an open question what Fed policymakers will do at their monetary policy meeting, which is to occur on Tuesday.

They will, as they have since December 2008, keep their target for short-term interest rates near zero and continue to state they expect to keep rates very low for an "extended period." But the economic outlook has worsened enough since their last meeting, in late June (and the risk of deflation risen enough) that the tone around the table is likely to differ substantially from recent meetings.

The Federal Open Market Committee will debate whether to take new measures meant to boost growth--and if so, what those measures should include. There is a confusing menu of possibilities of what will come out of the meeting, and here's an overview--from outcomes that are near-certain, some that are iffy, and others that are unlikely. Tune in at 2:15 p.m. Tuesday to find out which of these is realized.

Near-certain
The statement accompanying the Fed's policy announcement will very likely indicate a more subdued assessment of the economic outlook than officials had at the June 22-23 meeting, when the officials said that the "economic recovery is proceeding" and the labor market "improving gradually." Since then, there have been two straight weak jobs reports, new evidence that both industrial output and retail sales are growing only glacially, and disappointing data on second quarter growth.

Look for the policymakers' statement to make a nod to lower expected growth, a higher risk of substantial slowing, and some reflection of the view that the outlook is "unusually uncertain", as Chairman Ben Bernanke's put it in congressional testimony last month.

Fed policymakers also will likely dial down their expectations for inflation still further. At the last meeting, they said that "inflation is likely to be subdued for a time," but since then price pressures have diminished further, raising the prospect of deflation.

And they are likely to make clear in the language of the statement that they stand ready to take further action to support the economy and prevent deflation, should conditions warrant.

Just maybe
The big question is whether Fed officials, having adjusted their outlook, will follow it up with any substantive change. This debate comes down to two questions. 1) Will the action be effective at propping up and encouraging growth and reducing the risk of deflation, and 2) Even if it doesn't have a direct effect, will it have the beneficial effect of signaling to markets that the Fed is in a more accommodating mood?

One substantive option on the table--and which has the highest likelihood of actually being taken, though it is no sure thing--would be to state that the Fed will maintain the current size of its balance sheet, $2.3 trillion, by buying new assets as the mortgage backed securities in its portfolio mature. That would have only a moderate impact in terms of increasing the money supply, but would be a signal that the Fed has entered a more dovish mode.

Similarly, the Fed could strengthen its statement that economic conditions "are likely to warrant exceptionally low levels of the federal funds rate for an extended period." One fairly significant change would be to state how long an "extended period" is, such as two or three years. Another aggressive change would be to state that low interest rates are likely to be warranted until certain economic conditions are met, such at an 8 percent unemployment rate and core inflation above 2 percent.

Another possibility would be to cut the interest rate on excess reserves that banks park at the central bank, currently 0.25 percent, to zero. This would technically be a decision of the Fed's Board of Governors, not the full FOMC, (though Bernanke, given his collaborative style, will surely allow an airing of the debate at the FOMC even though any action would be taken by the board). On substance, the big question is whether the technical problems this action would create in the money markets would be worth the very modest benefits it creates for the economy. While in theory it would create greater incentive for banks to lend, in practice it would lead banks to shift money away from the Fed and into other ultra-safe investments like Treasury bills, creating only minimal economic bounce.

One more possibility: Eric Rosengren, the president of the Federal Reserve Bank of Boston, could dissent from the Fed's decision, calling for more aggressive intervention to support growth (he dissented in late 2007 as well, preferring sharper interest rate cuts). And Thomas Hoenig, president of the Kansas City Fed, who has been calling for tighter monetary policy, could well chose not to dissent for the first time this year. If one or both men change direction, it would be a clear signal that sentiment on the committee has shifted, even if it would have zero macroeconomic impact.

Not gonna happen

Never say never, but a new, large-scale program of asset purchases known as quantitative easing does not appear to be on the table at this meeting. Rosengren and a handful of other members may be interested, but the center of the committee, including Chairman Bernanke, hold to their view that the economy is likely to continue expanding at a gradual pace. Moreover, they are skeptical that it would pack enough of an economic punch to be worth the risk--of an inflation problem down the road, or of fears that the Fed is monetizing the debt, for example.

If Bernanke and company were to change direction and announce new asset purchases in the hundreds of billions of dollars, it would be a very surprising outcome--and likely reflect a "risk management" approach. The idea would be that a dip back into recession and toward deflation is unlikely, but would be so disastrous that the Fed should take aggressive steps to head off even the risk.

Even less likely than major new asset purchase program would be ideas advanced by Nobel laureate and New York Times columnist Paul Krugman (who frequently cites a speech by Bernanke himself), such as explicitly increasing the Fed's inflation target from its current 2 percent, or entering a price-level targeting regime in which it would promise future inflation high enough to make up for any period of below-trend inflation. Those are viewed on the FOMC as radical steps that would only be considered if conditions were much worse than they are now.

By Neil Irwin  |  August 9, 2010; 12:15 PM ET
Categories:  Federal Reserve , U.S. Economy  
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Comments

Just keep printing that money Benny Boy. Just keep making electronic entries of cash into your friends and "faithful" at the big banks and Wall Street firms.

Keep lying about inflation.

That'll work!!!!

Posted by: hz9604 | August 9, 2010 1:22 PM | Report abuse

Interest rates are at record lows. Companies are raising debt just because it is so cheap. So just what is the Fed going to accomodate. All they can possibly do is shovel some more cash into the system where it can lie in wait for the chance to do some damage when some part of the economy suddenly begins to overheat.

Posted by: Anonymous | August 9, 2010 4:14 PM | Report abuse

No matter what they do, they can't stop deflation and huge stock market crash. 2010 will be fun year : )

Posted by: Anonymous | August 10, 2010 2:55 AM | Report abuse

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