FOMC Amid Turbulent Time for Globe

First it was the tensions in North Africa that has since turned into a civil war in Libya drove up the price of crude, highlighting concerns about the globe’s ability to cope with surging energy inflation. Last Friday, the earthquake and tsunami in Japan unleashed a whole different kind of wave of anxiety, as global equities and especially shares on Tokyo exchange were battered by panic selling in Monday’s and Tuesday’s trading. The incidents at the nuclear facility in Japan, in which a radiation leak seemed eminent, only accelerated the rush to safety.

What to Expect Today from the Fed

The Fed, which already has a pretty straightforward plan in mind heading into this meeting, is not about to add the prospect of a hawkish FOMC to the volatile mixture.

The Fed us is on a steady course to finish its $600 billion in Treasury purchases, due to end in June. The FOMC continues to use the “extended period” language in its statement in regards to its ultra low interest rates. That tells the market the Fed is not going to consider raising rates for another 6 months out.

The Fed will likely upgrade its assessment of the economy, after February non-farm payrolls showed the US creating close to 200K jobs. Still, the Fed will need to see “a sustained period of stronger job creation”, in other words they are not close to beginning its exit strategy. While a stronger assessment would be a USD positive, it comes amid the knowledge than the Fed is still far from raising rates.

The Fed also isn’t feeling pressure from inflation, as the Fed’s preferred inflation gauge, excluding food and energy, was the lowest in five decades during December and January.

The divide within the Fed is between those that believe that higher inflation poses a threat, and those that see the spare capacity in the US and see that slack helping to keep inflation contained.

Bernanke said he doesn’t expect a permanent boost to prices from the recent surge in commodity costs.

As we get closer to the end of QE2, the speculation around the Fed will heat up. Today however, we are looking for a Fed still cautious about the US recovery and now global events.

Therefore, I don’t expect any shifts to interest rate expectations to come from this meeting.

Looking Forward Towards the End of Quantitative Easing 2

The important moment now comes as the Fed is getting set to complete the $600B of QE2 in June. That will be the time the Fed has to decide on some other things as well.

For how long will the Fed go on re-investing maturing debt once QE2 is complete? And how long will it choose to keep its balance sheet at a steady level?

The Fed’s balance sheet has grown to 2.3 trillion. If market conditions are getting better, then the Fed should be able to offload some of those assets on the market and shrink its portfolio.

The Fed also has to decide what to do with Treasuries that are coming to maturity. The Fed began re-investing maturing debt in August of 2010, but this would be one of the important things to go in an exit strategy.

What will the Fed decide about this policy once we get to the end of QE2? The consensus among economists ranges from the Fed stopping re-investing right after QE2 is complete, to continue re-investing for 1-3 months, for 4-6 months, for 7-9 months, or for more than 9 months.

A Bloomberg survey broke it down this way: “Five of 50 respondents said the Fed would halt the policy once QE2 ends; 11 said it would keep reinvesting for one to three months; 16 said four to six months; 14 said seven to nine months; and four said more than nine months.“

The end of QE2 and the the end of re-investing of maturing bonds will take away an important level of support for US Treasurys in the bond market. That could mean higher yields because of lower demand (bond prices and yields move inversely with each other). Higher yields can make the USD stronger as it makes US assets more appealing to foreigners, but it also has the effect of making borrowing for households, companies, and banks higher which can be a headwind on the overall economy.

How delicately the Fed signals and lays out its exit strategy and how it executes it will decide how bond markets react which can dictate how the USD reacts.

Nick Nasad
Chief Market Analyst
FXTimes

Information and opinions contained in this report are for educational purposes only and do not constitute an investment advice. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness. FXTimes will not accept liability for any loss of profit or damage which may arise directly, indirectly or consequently from use of or reliance on the trading set-ups or any accompanying chart analysis.