Outlook FOMC

The FOMC will conclude its two-day meeting on Wednesday and we do not expect a substantive change in its economic or inflation assessments. Nor do we think its guidance that conditions will likely "warrant exceptionally low interest rates for an extended period of time."

Even though the December non-farm payrolls report disappointed, it is still fair to say, as the FOMC did in mid-Dec that "deterioration in the labor market was abating." It may have to drop its assessment that the housing sector is showing some signs of improvement, after a recent string of poor news. The very cautious optimism can be retained and the assessment will likely receive quick confirmation in the way of Q4 GDP that will contrast marked with news from Europe--where the UK just reported 0.1% Q/Q).

The inflation assessment can also be maintained. Resource slack continues and long-term inflation expectations remain stable. For example, the 5-year/5-year forward stood at 2.78% on Dec 16, the conclusion of the last FOMC meeting. Today it is around 2.65%.

There may be some update on the winding down of its long-term asset purchases.

There has been some discussion that one of the potential courses of action for the Fed to compliment its reserve repo and terms funds structures that have also been suggested, would be to use its deposit rate (the interest in pays on excess reserves) as its new target rate, effectively demoting the significance of the Fed funds rate. Fed Chairman Bernanke told Congress last summer that interest on reserves may be the Fed's most important tool to tighten credit conditions. It was also supported by Richmond Fed President Lacker in a speech earlier this month. Some other economists seem supportive of the concept. The deposit rate currently stands at 25 bp. It would be somewhat surprising for the Fed to announce any change in the deposit rate or its status at the conclusion of this FOMC meeting. Any such announcement would be seen as preparing the market for tightening and could lead to a sell-off in equities and a bolster the dollar. While the short-end of the debt market would likely sell-off, it seems less clear what the longer end of the curve would do--get dragged down by the short-end or do relatively better on enhance anti-inflation credibility and/or risks slowing the economy?

Lastly, we expect the Senate to confirm Bernanke's nomination for a second term. The challenge however could have an impact on the FOMC meeting in two ways. First, the FOMC votes on their own chairman and could very formally re-elect Bernanke as a show of support. He is after all a member of the Board of Governors until 2020, leaving aside his role as Chairman of the Federal Reserve Board. Second, although there have not been dissents from recent FOMC statements, the political challenge to Bernanke would seem to underscore that there won't be this time either.