There are four major things to keep in mind when the U.S. Federal Reserve's policy-making committee meets this week to decide what, if anything, to change in its approach to supporting the economic recovery.
1. The Context
The majority view at the Fed is that a healing U.S. economy is gradually approaching "liftoff," and that the economic weakness experienced earlier this year can be attributed largely to unseasonably cold weather. Because policy makers believe the pickup in growth is likely to happen in an economy that has been operating below potential, the Fed isn't very concerned about inflationary pressure. If anything, the worry is that inflation could be too low.
The Fed’s post-meeting statement will provide updated insights on officials' comfort with this contextual characterization, with a fuller picture emerging when the minutes of the meeting are released three weeks later. In the meantime, don't expect any dramatic changes in the Fed's assessment of the economy, positive or negative. And don't expect much talk of either "secular stagnation" -- the idea that the U.S. has entered an extended period of slow growth and persistently high unemployment -- or the threat posed by Ukraine’s deepening geopolitical crisis.
2. Policy Decisions
Given the Fed's relatively sanguine outlook, expect it to continue the gradual phasing out of its extraordinary bond-buying program, known as quantitative easing. Specifically, it will probably announce a $10 billion reduction in its monthly purchases of U.S. Treasuries and mortgage-backed securities, to $45 billion a month. Although the Fed will undoubtedly reiterate its willingness to change course if necessary, this will do little to dislodge consensus market expectations of a total exit from quantitative easing later this year. Indeed, only a major economic surprise -- and, I stress, major -- would alter the current policy course.
Look for the Fed to hold its short-term interest-rate near zero, and to provide additional guidance on the future course of interest rates as part of its broader goal of enhancing transparency. Such forward guidance includes more holistic measures of the labor market, as opposed to the unemployment rate alone, and a move toward putting greater emphasis on inflation metrics. All this will be done in the context of an important pivot from a target-based approach, such as the calendar guidance the Fed was providing not long ago, to an objective-based one.
3. Market Reactions
The big question is not whether the Fed will still come across as generally dovish. It most probably will. The real question is how markets will react to the inherent short-term uncertainty engendered by the shift in the underpinnings of forward guidance -- a pivot that major segments of the fixed income markets have started to understand, but that other market segments still haven't grasped.
This week’s meeting will probably be the last for Fed Governor Jeremy Stein, who is returning to Harvard University. Stein will be remembered for pointing out the dangers that excessive risk-taking in financial markets can pose, particularly when aided by long periods of artificially low interest rates. It will be interesting to see whether this issue is given any greater prominence at the Fed this week, particularly given the increasingly slim expected compensation that yield-hungry investors are willing to accept for taking on credit, volatility and liquidity risk.
The bottom line: Don’t expect major surprises from the Fed this week, but keep a close eye on the underlying policy transitions. The good news is that the Fed will do its utmost to communicate as clearly as circumstances permit. The challenge for markets -- as Mario Draghi, the president of the European Central Bank reminded us last Thursday -- is that "despite these efforts to enhance transparency, the predictability of the past will not readily return."
Corrects timing of meeting minutes in fourth paragraph.
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