FOMC Meeting: Focus is on two aspects of policy statement

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This post is a guest contribution by Asha Bangalore* of The Northern Trust Company.

The FOMC meeting of April 27–28 is nearly certain to end with no change of the federal funds rate. The key phrase “exceptionally low levels of the federal funds rate for an extended period” is predicted to be retained and it is the first aspect of the report markets will react to after the policy missive is published.

In light of these developments and the robust growth in home sales in March could result in a modification of the policy statement such that it is more bullish in tone compared with the March statement.

In addition to these two aspects embedded in the policy statement, the Fed’s revised opinion about the status of the labor market, bank lending, and consumer spending will be of interest. The March policy statement depicted the labor market as stabilizing and consumer spending as “expanding at a moderate rate”, while bank lending was reported to be contracting. The gains in payroll employment and elevated level of claims present a mixed labor market. Retail sales in March was strong on all fronts and bank lending is contracting at a decelerating pace.

The second aspect markets are focused on is the timeline with regard to the potential sales of mortgage-backed securities. Chairman Bernanke has indicated that the Fed does not anticipate to “sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery”. However, there is growing support for the sale of these securities within the FOMC. Word from the Fed indicating that it has plans to sell these securities in the months ahead will spook markets because it would suggest that the housing market is on a sustained growth path and higher mortgage rates are not a hindrance.

Incoming reports suggest that this optimistic scenario is far from the truth. The Fed is likely to touch on the issue of mortgage-backed securities in terms of tests it is performing and may be offer guidance about the timeline for sales. The term deposit route and a higher interest rate on reserves are expected to be the options the Fed shall employ to drain reserves in the banking system before reducing the size of its balance sheet by outright sales of mortgage-backed securities.

Source: Northern Trust – Daily Global Commentary, April 26, 2010.

* Asha Bangalore is vice president and economist at The Northern Trust Company, Chicago. Prior to joining the bank in 1994, she was consultant to savings and loan institutions and commercial banks at Financial & Economic Strategies Corporation, Chicago.

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