The Federal Reserve, meeting next week to set monetary policy, faces the tricky task of acknowledging a pick up in economic activity without spooking fragile markets into believing interest rate hikes are imminent.
To accomplish that, the central bank will likely try to find a way to capture a somewhat brighter economic outlook in its policy announcement, while maintaining its pledge to keep borrowing costs at near record lows for an extended period.
At a time of uncertainty about the nation's economic prospects, which continue to be hampered by the worst labor market since the early 1980s, small nuances may be particularly relevant to Wall Street's usual game of parsing out Fed-speak.
As the guesswork begins, the following are some scenarios worth considering:
PLUS CA CHANGE: STEADY POLICY COURSE
In the face of a sharp deceleration in the pace of job losses and surprising resilience in consumer spending, some analysts think the Fed has to begin toning down its open-ended commitment to its ultra-accommodative policy stance. However, in a speech on Monday, Ben Bernanke proved reluctant to read too much into a single month's worth of data. That suggests the Federal Open Market Committee will err on the side of inaction, opting to leave its statement mostly alone given that inflation does not appear to be an immediate concern. A recent decline in oil prices and a rebound in the U.S. dollar have made the Fed's life easier, reinforcing the chances of this outcome. A report on Friday showed consumers' expectations of future inflation declining. Tweaks in language could be made around the edges, such as nods to improvements in consumer spending and jobs.
* Probability: High
* Market Reaction: Stock and bond prices should rise under these circumstances, while the dollar would probably give up some of its recent gains, which are based in part on the perception of deteriorating conditions in Europe. There is an off-chance, however, that equity investors would be disappointed that the Fed is not more enthusiastic about the recent data and sell.
There is always some chance, of course, that the Fed will prove more upbeat than markets now expect, offering some sort of signal that the vaunted exit strategy is a step closer to implementation. This possibility got some reinforcement on Friday from data showing much stronger-than-expected readings on retail sales and consumer confidence. The Fed could seize on such developments to present a much more positive view on the economy, tone down or scrap its low-rate vow, or make a more extensive reference to the tools it possesses to withdraw monetary stimulus from the financial system. Already, investors have been watching with interest as the central bank tests its ability to conduct larger-scale reserve draining operations known as reverse repos.
* Probability: Somewhat low
* Market Reaction: In this instance, the primary beneficiary would be the U.S. dollar. A hawkish statement would corroborate the notion that global interest rate differentials, long working against the greenback, might finally turn in its favor. Stocks, already having a hard time scoring further gains after surging more than 60 percent since March, would probably veer lower. Treasury bonds could go either way, depending on whether the move comforts inflation vigilantes or irks holders of shorter-term securities.
DOVISH BLACK SWAN
Tucked into Bernanke's testimony to Congress on December 3 was a small hint at the possibility, supported recently by St. Louis Federal Reserve Bank President James Bullard, that the Fed could actually do more rather than less in its asset-purchasing programs. It is a monetary policy decision and the committee will have to see how the economy evolves and whether or not we need to do more, Bernanke said. While highly unlikely to take place at this meeting, this statement from the chairman keeps alive the possibility that the Fed may at some point decide to signal it will need to keep its program to purchase mortgage-back bonds alive or resurrect its Treasury-buying program.
* Probability: Very Low
* Market Reaction: Because an increase in asset purchases is so far off the market's radar, it is difficult to gauge potential reaction. One of the reasons the Fed would likely refrain from this option without greater forewarning is that it could be interpreted as showing the Fed is a lot more pessimistic about the recovery's sustainability than the bankers on Wall Street. The dollar would almost surely renew its slide.