By Jennifer Yousfi
Economists and investors wait with bated breath for the U.S. Federal Reserve to release the statement from the Federal Open Market Committee this afternoon (Wednesday) at 2:15 p.m. EDT.
While it is almost universally expected that the FOMC will vote to hold the Federal Funds rate steady at its current 2.0%, the language in the accompanying statement will be scrutinized for clues about the upcoming August and September meetings.
In a recent Bloomberg News survey, all 101 economists queried expect the Fed to pause on any further rate actions for the time being. Many believe there will be no movement in the key interest rate until mid-2009 at the earliest.
But traders have a different view, as demonstrated by Fed Funds futures traded on the Chicago Board of Trade. Those futures are predicting very slim odds of a rate change tomorrow, but are currently pricing in a 36% chance of a rate hike at the FOMC's August meeting and 93% odds of a rate hike in September.
Recent comments by Fed Chairman Ben S. Bernanke have helped boost traders' expectations of a reverse in course after one of the most aggressive rate-cutting campaigns in recent history slashed the Fed Funds rate 325 basis points from 5.25% last September.
But there's no clear-cut course of action before the Fed, as the FOMC must carefully weigh the dual threats of stagnation and inflation that are now facing the U.S. economy.
It's true that commodity prices are soaring with oil over $135 per barrel and food costs causing an escalation of global hunger problems. Even excluding the volatile costs of food and energy, the so-called "core" consumer price index is running at a 2.3% annual clip, above the Fed's desired 2.0% inflation target. That would seem to point to a rate increase as the obvious choice.
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But several recent economic reports show the U.S. economy remains sluggish at best, and consumer sentiment is at a record low. Unemployment is on the rise at 5.5% in May. The housing market continues to suffer and be a drag on other sectors of the economy, while some areas of the credit markets remain near frozen.
"We think the U.S. economy is still too fragile for a rate hike and thus expect the Fed to stay on hold – this time and also during the next meeting," Harm Bandholz, an economist for UniCredit, wrote in a note to clients, Reuters reported.
The Fed must execute caution, as a hasty switch in tactics could do more harm than good. Economic recovery is far from a certainty at this point.
"That's the dangerous game," Scott Anderson, senior economist in Minneapolis at Wells Fargo & Co. (WFC), the fourth-largest U.S. bank by market value, told Bloomberg News. "Instead of putting the shot across the bow on inflation," Bernanke might have "held off a few more months to let the credit crisis heal a little bit more."
At least two Federal Reserve Bank presidents are more concerned with inflation than slow economic growth. Richard Fisher, president of the Federal Reserve Bank of Dallas, and Charles Plosser, president of the Federal Reserve Bank of Philadelphia, both voted against lowering rates at the last two FOMC meetings.
Things could get ugly if Bernanke chooses not to follow through on his recent position against inflation and in favor of strengthening the dollar.
"Unless the inflation expectations and the numbers come down, they're going to have to raise rates," William Ford, a former Atlanta Fed chief who's now at Middle Tennessee State University in Murfreesboro, said in a Bloomberg Radio interview. "If [Bernanke's] saying we're going to fight inflation but he's all bark and no bite, division is what's going to happen."
A dissent this time around, when a vote to hold rates steady is expected, would be a very hawkish sign as it would mean Fisher and Plosser are willing to raise rates in order to stave off further inflation.
Bernanke's counterpart across the Atlantic, European Central Bank (ECB) President Jean-Claude Trichet has publicly proclaimed inflation his top priority and has even gone so far as to suggest the possibility of an ECB rate increase as early as July, which would only serve to further strengthen the euro against the struggling greenback.
Propping Up the Dollar
Currency traders are looking for a statement that alludes to future rate increases in order to prop up the buying power of a weak dollar.
"There's no real belief that we'll see a rate hike, but it's the accompanying comments that will provide the most meaningful direction, and a hawkish tone could easily see the greenback lock in the latest gains on a more permanent basis," James Hughes, currency strategist at CMC Capital Markets, told MarketWatch.
The dollar traded in a narrow range ahead of the FOMC decision. The dollar index, which measures the green back against a basket of six major foreign currencies, was down slightly with a 0.3% decline in late afternoon trading.
"Even if the dollar/yen were to go down after the FOMC meeting in reaction to what they say in the statement, I think the downside of the dollar is limited," Satoru Ogasawara, foreign-exchange analyst and economist at Credit Suisse Group AG (ADR: CS) in Tokyo, told MarketWatch.
"There is now the perception that the U.S. doesn't want the dollar to weaken," Ogasawara added.
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