NO EXIT : FOMC REMAINS ON HOLD / BARRON´S

Thursday, June 25, 2009

UP AND DOWN WALL STREET DAILY

No Exit: FOMC Remains on Hold

By RANDALL W. FORSYTH

Despite "improved" financial markets and an energy uptick the Fed stays the course on monetary stimulus.

THE FEDERAL RESERVE IS NOT PROVIDING HINTS about any exit strategy from its policy easing.

Following its two-day policy meeting, the Federal Open Market Committee Wednesday reaffirmed its rock-bottom 0%-0.25% federal-funds rate target and its plans to purchase up to $1.75 billion of Treasury, agency and mortgage-backed securities.

But for bond-market vigilantes looking for Bernanke & Co. to set a timetable to begin to reverse their policy of aggressive credit easing, it was a disappointment. Treasury yields ticked higher.

Since the FOMC's previous meeting on April 29, the Fed's policy-setting panel noted, "Conditions in financial markets have generally improved in recent months," a nod to the sharp rallies in the equity and corporate fixed-income markets, both investment-grade and high-yield.

The Committee also noted, "The prices of energy and other commodities have risen of late." That was a reversal from the observation at previous meetings that "inflation could persist for a time below rates that best foster economic growth and price stability in the longer term." In other words, the dreaded D word, deflation.

But the FOMC was quick to add this time: "However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time."

Indeed, by pointing out that "economic activity is likely to remain weak for a time," the monetary authorities clearly signaled their policy stance remains on hold for "an extended period." The panel's vote on the policy action was unanimous, as it was at the April meeting.

While the Fed did not lay out any exit strategy for its current program of aggressive easing to combat the worst credit contraction since the Great Depression, it left itself some wiggle room to reassess its program of securities purchases.

"The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted," a slightly more definite and less-conditional tone than it took in the previous statement.

That could be significant should the central bank decide to alter the mix of its securities purchases, which currently are projected to consist of $1.25 trillion of agency MBS and $200 billion of agency debt purchased by the end of the year and $300 billion by autumn. Given the rise in mortgage rates, the Fed might want to tilt more to MBS purchases to try to bring down the cost of loans for home purchases and refinancings, which have been flagging in recent weeks.

Even with the Fed's acknowledgement that "the pace of economic contraction is slowing" -- a far cry from a recovery -- the financial futures markets continue to put better than two-to-one odds on a rate hike by year's end.

The December fed-funds futures contract puts a 69% probability on a half-point hike in the current funds target at the Dec. 15-16 FOMC meeting, unchanged from Tuesday, Dow Jones Newswires reports. The February 2010 contact fully prices a half-point hike for the Jan. 26-27 meeting.

Yet, the overall outlook for Fed policy remains unchanged among economists.

"The Fed is not going to hike anytime before mid-2010, at the earliest, and more likely 2011," writes T.J. Marta in his Marta on the Markets advisory.

"The Fed is highly likely to hold short rates at rock-bottom levels until the volume of economic "slack" (output gap) is substantially lessened, which means short rates are unlikely to rise anytime soon (i.e., before late 2010)," adds Michael Darda, chief economist and strategist for MKM Partners.

That seems more reasonable than the expectations of the players in the futures pits.

Even if an economic recovery takes hold in the second half of this year, as the consensus forecast holds, even such optimists agree that the unemployment rate is likely to continue to rise into double digits next year, well after gross domestic product readings turn positive. That has always been the cyclical pattern.

The other norm in past cycles has been that the Fed has never raised the fed-funds target until the jobless rate has clearly peaked and was in an unambiguous downtrend. That may have more to do with politics than economics, but it's a fact nonetheless.

Some in the bond market apparently were expecting a break from that precedent. They'll have to keep waiting.

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