The Fed is meeting tomorrow and Wednesday, and on Wednesday afternoon, it will announce the decision on the Fed Funds rate and release the policy statement, followed by a Ben Bernanke news conference. What do I expect?
- No change in the Fed Funds rate, which has been stuck in a 0 to 0.25% range since December 2008. The earliest I see any change is early 2012, and most likely later than that.
- No change to the key “exceptionally low levels for the Fed Funds rate for extended period of time” language.
- The second round of Large Scale Asset Purchases, also known as Quantitative Easing or QE2, will be completed on time by the end of the month. There will not be a third round. The Fed will, however, continue to reinvest the proceeds of the coupons and maturing securities, keeping the size of the Fed balance sheet constant.
- The policy statement will probably reflect more concerns about softness in the economy, but point to the hopes for higher growth in the future.
- The statement will also acknowledge somewhat higher inflation, but will deem it to be temporary and will point to the recent decline in oil prices as evidence of that.
- The growth forecasts for this year will be lowered. Those will not officially come out until the minutes are released in a few weeks, but Bernanke will probably “spill the beans” about the key highlights in the press conference. In April, the Fed lowered its 2011 GDP growth forecast range to 3.1% to 3.3%, down from a projected range of 3.4% to 3.9%. With first quarter growth of 1.8%, and the second quarter likely to be similar, the growth forecast for the whole year is likely to be lowered again. If the first half growth averages 1.8%, then to get to the mid-point of the April range, then growth in the second half would have to average 4.6%. With monetary policy turning neutral — and fiscal policy turning concretionary — I don’t think that sort of growth is likely in the second half. The lower end will probably become the top end of the range, with the lower end falling to about 2.7%. The forecast for 2012 was cut to a 3.5% to 4.2% range from 3.5% to 4.4%. I suspect that both the top and bottom ends of that range will be trimmed.
- In April, the headline inflation forecast was raised to a 2.1 to 2.8% range for 2011 and 1.2% to 2.0% for 2012, from 1.3% to 1.7% and 1.2% to 2.0%, respectively. With oil prices having reversed their rapid climb this spring, I suspect the Fed will keep the headline inflation numbers the same as in April. In June, the CPI headline will probably be negative, offsetting some of the rise early in the year. Food prices may continue to be a problem. The very wet weather in the Midwest is likely to make for a very poor corn and soybean crop this year.
- The core inflation forecast ranges also rose in April, to 1.3% to 1.6% for 2011, up from the January forecast of a 1.0% to 1.3% range. I suspect that range will be tweaked up a bit, perhaps to a 1.5% to 1.8% range. For 2012, the April forecast was raised to a 1.3 to 1.8% range from 1.0% to 1.5% range. The bottom end of that range will probably rise slightly.
Overall, the sense is that the Fed is likely to simply sit on its hands for the rest of the year. The bar is set very high for any real change in Fed policy. Inflation will have to come in much higher than forecast for the Fed to start to tighten. Any tightening will tend to exacerbate the already awful unemployment situation.
While I think that QE2 was successful, the help was marginal, clearly not game-changing. When QE2 started, there was a clear and present danger that the economy would slip into deflation. QE2 prevented that from happening, and it is no longer a major risk. How much a third round of quantitative easing would help is a very open question. It sort of looks like trying would be pushing on a string.
Still, I see the main problem in the economy is weak growth and high unemployment, not runaway inflation. Thus, if the Fed does move, it is more likely to move in the direction of additional easing than toward tightening. The most likely case, though, is a fairly prolonged period of sitting on the sidelines.
Lower gasoline prices will provide a little bit of stimulus to the economy in the second half. Japanese supply chain pressures should ease, and there is substantial pent-up demand. However, those factors are probably not enough to substantially accelerate the overall economy, at least not to anything close to what is implied by the April growth forecasts.
Austerity measures at all levels of government will continue to be a major drag on both growth and employment, and will work to offset the oil price decline stimulus. There is also no guarantee that the price of oil will continue to fall. I suspect we are getting pretty close to a floor level for it. However, the effects of the decline since late April have not really filtered into the economy yet.
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