Tags: interest | rates

Analysis: Fed to Go Slow on Raising Rates

Wednesday, 12 Aug 2009 11:57 AM

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WASHINGTON -- The Federal Reserve is expected to pledge ongoing stimulus to lift the economy out of recession and also to find words to reassure markets that recovery is coming as it wraps up a two-day meeting here Wednesday.

The Federal Open Market Committee concludes a policy meeting Wednesday widely anticipated to hold unchanged its key federal funds rate at a record low range of zero to 0.25 percent to spur lending and economic activity.

Markets will be watching the FOMC's statement accompanying its decision for clues about the momentum of the world's largest economy, which is showing signs of emerging from the worst slump since the Great Depression.

Joseph LaVorgna, economist at Deutsche Bank, said he believes the Fed statement will show "further modest upgrades" to the economic outlook after a modestly improved tone at its June meeting.

"However, we think the tone will be sufficiently restrained so as not to spark inflation concerns," he added.

"We continue to anticipate the first Fed rate increase sometime in 2011, although another forecast upgrade could push the preliminary hike into the fourth quarter of 2010."

He argued that the Fed "has never lifted rates when the unemployment rate was rising" and that if job losses continue it will keep the Fed on hold.

"The economy is clearly moving into recovery, but that recovery is still extremely fragile," said Diane Swonk, chief economist at Mesirow Financial.

"This means that the Fed will remain vigilant in its support of credit markets and will keep rates close to zero well through the spring of next year."

Others agree that the Fed, led by chairman Ben Bernanke, will maintain a stimulative policy.

"The odds are high the Fed will err on the side of caution and boost rates later than it should," said Kent Engelke, chief economic strategist at Capitol Securities Management.

"Bernanke is the premier student of the Depression. To refresh all, the Federal Reserve increased interest rates prematurely in 1931, action many historians believe is a reason why the economy turned even lower. I doubt Bernanke will risk repeating the same mistake."

Markets will focus on whether the Fed will adjust its unprecedented efforts to pump over one trillion dollars of liquidity into the stricken financial system, which some call "quantitative easing."

"The Fed and chairman Ben Bernanke have made it very clear that they will stay the course, which means don't expect any changes in policy or wording," said Joseph Balestrino, strategist at Federated Investors.

"If anything, the Fed may acknowledge recent economic 'improvements,' but we don't expect it to signal any change this year in the target federal funds rate ... Nor do we anticipate any change in its quantitative easing measures, which have worked to bring stability and liquidity to the debt markets."

Yet some say the Fed will be doing more to prepare an "exit strategy" to pull back some of the extra liquidity, even if that is just scaling back the purchases of Treasury and mortgage debt.

"With the recession probably already over, the Fed is approaching the point when it will likely start winding down quantitative easing," said Morgan Stanley economist Ted Wieseman.

Kevin Giddis at Morgan Keegan said he expects "an assertion that the Fed is fully prepared to withdraw excess liquidity when conditions warrant."

But he said that this may test the health of the credit markets if the Fed does nothing to expand the quantitative easing.

"Unless the size of the program is expanded, the Fed appears poised to complete the 300 billion dollars in Treasury purchases sometime in September," Giddis said.

Copyright © 2009 Agence France Presse. All rights reserved.

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