The Fed Faces a Faltering Recovery
In May, the economy created 54,000 payroll jobs, too few to even keep up with population growth, auto sales fell substantially, retail sales slowed, manufacturing output growth fell off significantly, house prices reached new post-bubble lows (as of March), and home sales were sluggish. In addition, claims for unemployment insurance have been elevated, consumer sentiment has weakened, and corporate bond issuance "fell to its slowest pace of the year." And if that's not enough, ARRA spending and QE2 are coming to an end, and state and local budgets are still a problem.
Thus, there are substantial headwinds pushing against the recovery, but there is uncertainty over how long they will persist (good discussions of this can be found at the SF Fed and Calculated Risk). My own view is that the weakness is likely to be with us for awhile, and that it would be a mistake for policymakers to dismiss the recent data as a temporary blip in the recovery.
Decisions the Fed Must Make
As noted above, QE2 -- which expanded the Fed's balance sheet in an attempt to stimulate the economy -- is coming to an end. In response, the Fed can make three choices. It can expand the balance sheet further by moving on to QE3, maintain the balance sheet at its present size, or begin reducing the size of its balance sheet immediately (i.e. sell the assets it purchased during QE1 and QE2).
The other decision is must make is whether to increase the target interest rate, and if so by how much, or leave it at its present level.
What Will the Fed Will Do?
I think the chances of QE3 at this point are non-existent. If the economy continues to weaken, then perhaps the Fed will consider it, but conditions are not yet bad enough for the Fed to take this step.
If anything, the Fed is inclined to move in the other direction. The Fed has reached new ground with its swelled balance sheet and, as Bernanke made clear in the press conference after the last meeting, the Fed is not entirely sure what to expect. The desire to reduce this uncertainty makes the Fed anxious to return the balance sheet to a more familiar size.
When will the balance sheet reduction begin? The first thing that will happen is that the Fed will stop reinvesting maturing securities, and after a time it will also begin selling the financial assets it accumulated during QE1 ad QE2. Several months back I expected the first step to happen in late summer. But now I expect it to be much later than that, near or past the first of the year. And once it does begin, I expect the Fed will move at a measured pace to avoid upsetting financial markets.
As for interest rates, the Fed won't begin increasing rates until after balance sheet reduction is well underway. Thus, I don't expect to see an increase in the target interest rate before the year has ended, and it will likely be several months after that -- perhaps even longer. And, like balance sheet reductions, I expect the increases to proceed at a relatively slow rate.
Key Things to Look For
The results of the meeting will be communicated in the press release that is posted on the Fed's website when the meeting is concluded, and in the Press Conference Ben Bernanke will hold shortly thereafter -- his second since the Fed began this practice. Here's what to look for:
Press Release: In the press release, look for any changes in language related to the Fed's outlook for the economy. This will help to determine when the Fed is likely to begin reversing policy (again, I don't think QE3 is likely unless there is a substantial deterioration in the outlook). In particular, look for indications of whether the Fed sees the current weakness as a bump in the road, or something more persistent. The more persistent the weakness appears, the longer policy is likely to remain on hold.
I will also be looking for any change in the language about inflation. Is the Fed more worried about inflation than before? If inflation worries intensify, the Fed is likely to reverse course sooner.
Press Conference: In the press conference Bernanke will hold after the meeting ends, look for signals about the same things -- how the Fed views the present slowdown and how worried it is about inflation. In addition, as Jill Schlesinger says, "Of particular interest will be ... whether Ben Bernanke gives any hint of a potential QE3." Will there be any signs of willingness to move on to QE3 should conditions worsen? If so, how bad do things have to get? I expect the bar for further action is high, but what can we learn about how high the bar actually is?
Finally, how does the Fed see the unemployment problem? Is it largely cyclical or structural? If its cyclical, the Fed is more likely to act if the economy worsens, but if its structural there's little the Fed can do. I think the problem is mostly cyclical, but what is the Fed's view on this?
Summarizing, look for:
- Whether the Fed sees the recent weakness in the economy as long-term or short-term
- If it's long-term and severe, whether the Fed is willing to try QE3
- Whether the Fed views the unemployment problem as mostly cyclical or mostly structural
- How worried the Fed is about inflation
- Signals about when the will Fed will begin reducing the size of its balance sheet
- Signals about when the Fed will begin raising its target interest rate