The Federal Reserve will emphasize that the US economy remains fragile in a policy statement later on Wednesday, as it talks down expectations for a rate hike this year and holds fire on expanding asset purchases.
Analysts widely expect that the US central bank will hold the benchmark overnight federal funds rate between zero and 0.25%, while emphasizing it will remain in this range for some time.
“With 'core' inflation beginning to moderate again, and legitimate threats to recovery still in evidence, officials have scant reason to turn hawkish,” Morgan Stanley economist Richard Berner wrote in a note to clients.
US core inflation, which excludes volatile food and energy costs, slowed to 1.8% year-on-year in May compared with 1.9% in April.
Fed officials have indicated that they would like to keep inflation close to, but under, 2%.
In addition, the US economy is widely expected to have contracted further in the second quarter, albeit at a sharply slower rate of decline than the 5.7% annualized drop seen in the first three months of the year.
But some recent economic data has been better than expected, helping to harden speculation in futures markets that the Fed would hike rates to 0.5% by the end of the year, although these bets have eased in the past week.
The Fed is expected to push back against the idea of a rate hike this year in the statement it will issue at the meeting's end. Economists are focused on how the central bank's language could be tweaked to accomplish this tricky communication.
Economists at Goldman Sachs said one option would be for the Fed to say something along the lines of “conditions are likely to warrant a federal funds rate in the current range for an extended period,” ruling out modest hikes to 1%.
At the Fed's last meeting on April 28-29, it said “conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”
The Goldman economists said their suggestion would offer a clearer signal.
Either way, officials may be wary of offering too explicit a commitment. In 2003-04, they vowed to hold rates low for a “considerable period,” and kept rates at a 1% for a year - a stretch which many economists say helped inflate the housing bubble.
“We're not calling for an exact repeat of the 'considerable period' ... but we wouldn't be surprised to see the Fed use a similar phrase that becomes part of the financial lexicon for the balance of 2009 and the first half of 2010,” said Michael Darda, chief economist at MKM Partners.
The Fed is not expected to ramp up asset purchases above an existing promise to buy $300 billion of longer-dated US government bonds and $1.45 trillion of mortgage debt, although it might make some minor changes.
Policymakers launched those programs to drive down mortgage rates and other market-set borrowing costs. While officials worry about the economy's weakness, they are also concerned expanding purchases further might spark concern their aggressive actions will eventually fuel inflation.
Some analysts say the Fed could instead stretch out its buying of longer-dated Treasuries, or possibly divert cash now earmarked for mortgage debt to purchase government bonds. Its current plans have it wrapping up its buying of Treasury securities by mid-September while the mortgage asset purchases would run until year-end. (Reuters)