Monday, June 22, 2009

What not to expect from the Fed

About two weeks ago there were concerns of too much growth in the US coming on stream too fast. Stock prices were up sharply and on a tear. Oil was moving up over $70/bbl and, as the Fed meeting approached, bond yields had spiked up. In looking for a way to stop the rise in long term yields and the threat they posed to the burgeoning recovery, some have suggested that the Fed would add some language to its statement at the meeting this week suggesting it would be some time before its rates would rise in order to calm markets.

But would that calm markets?

One thing we can be sure of is that the Fed will make no promise it can't keep. The Fed will not make any promises on how long it will be before it hikes rates.

The Fed might state that because of the size of the GDP gap it will be able to keep rates accommodative (or low) for a long time. But there will be no pledge not to hike rates.

The Fed knows it must implement a correct monetary policy and on top of that it might have to take some steps to salve the bond market. Ironically the Fed may have to raise the Fed funds rate before it wants in order to keep long term rates in check if the bond market is spooked by stronger than expected growth in the economy. That is a major complication.

But more to the point is the new development in markets: the factors that set all of this speculation in train have diminished and reversed in the past two weeks. US equity market indices are falling. US treasury yields have declined. Oil prices have tumbled back below $70/bbl. Economic data continue to show progress. But the sense of emergency is past.

It would not be surprising for the Fed to just put that tempest in a tea pot behind it and do nothing new at the upcoming meeting. No longer are any Fed words of solace needed.

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