Release: US FOMC Interest Rate Decision Consensus Forecast: <0.25% Previous: <0.25%

Date/Time: 03/13/12 2:15 PM ET (16:15 GMT)

Fed to Sit On Their Hands, While Slightly Upgrading The Assessment of Economy

In the upcoming FOMC statement we don't expect a big change from the Fed as Bernanke had a chance to telegraph any changes or new stimulus measures in testimony before Congress and when he didn't the markets responded by pricing out quantitative easing. Recent economic data including better non-farm payrolls helps to support the case that the Fed will slightly upgrade its assessment of the economy, will continue to strike a cautious tone as growth is not strong enough to materially bring about a downward change in unemployment rate.

There are a couple reasons that cautioned by the Fed in terms of the current recovery is warranted.

  1. The US economy may already be slowing. After a 3% annualized growth rate in the 4Q 2011 the forecast for 1Q 2012 is for growth that may be below 2%. After the strong job gains over the last three months, a peaking to job creation may be on the horizon.
  2. The US recovery will still continue to be vulnerable to external shocks including a possible oil spike if there is military conflict with Iran, as well as concerns that despite the Greek debt restructuring that we could face another round of pressure from the European sovereign debt complex. Lastly a slowing Chinese economy may dent the trade prospects for the US.
  3. Higher gasoline prices should filter through to consumers, leaving less room for discretionary spending. Unless job gains continue on pace, wages improve, or recent consumer credit growth is sustainable, the US consumer may retrench going forward, which would weaken the economy's prospects.

At the same time the Fed will likely be concerned about inflation prospects as can be seen from core CPI running above the 2% annual rate and a steady rise in that breakeven rates.


The breakeven rate looks set the real yield of the inflation linked five year bonds (TIPS) and compares it to the 5-year nominal maturity, giving the market the implied inflation rate for that time period.


As we can see above, the 5-year breakeven rate has increased during January and February and therefore may limit the room that the Fed has to introduce fresh monetary stimulus measures.

3 Scenarios and Expectations

1. Announcement of QE or Sterilized QE: Will the Federal Reserve announced another round of QE or some type of sterilize quantitative easing in Tuesday meeting? It seems unlikely. Instead this option will be held in reserve and shows that the Fed is concerned about the implications of more easing on inflation. There are also drawbacks to using this policy as it would raise short-term interest rates which could undermine the carry trade of banks who borrow short term and lend out long-term. Also this sterilize approach was expected to be used during the exit process of its easing not as part of easing itself.

2. Fed Clips The Wings of The Hopeful for More QE: What will be the market's reaction to a failure of the Fed to bring up QE3 or sterilized QE at all? Can it start a stronger correction in equities? The answer is likely that we won't  see a sharp sell-off as expectations heading into this event have not priced in mention of QE3 or sterlized QE after Bernanke's testimony to Congress two weeks ago. If the Fed offers further clarification or a stronger than expected upgrade assessment of the economy - thereby more strongly ruling out hope of more stimulus - it would have a negative impact. This too is not as likely, though slightly more so than the 1st option.

3. Fed Leaves Sterilized QE in its Quiver: The Fed is more likely to wait till Operation Twist is close to conclusion before telegraphing its new stimulus measures, therefore we might see a muted reaction to the FOMC statement. Unfortunately for those looking for more volatility this may be the most likely scenario. If the Fed keeps its general tone from the February statement, but leaves the door open for speculation around sterilized QE it shouldn't change the general dynamic of markets which may be expecting such a result.

Sterilized QE?

In this environment of heightened inflation expectations what if the Fed still wanted to conduct some type of quantitative easing in order to help the economy - either by buying the longer-term bonds to push down longer-term yields (flattening the yield curve) or buying mortgage-backed securities and therefore clearing extra capital on the balance sheets of banks which should open up lending.

With these concerns in mind the Fed did float a trial balloon last week by talking about sterilized QE.

Here is a description of how sterilized QE might work.

From MarketOracle: The idea is that the Fed purchases securities in the market and then lends them out via repo. Legally the Fed is borrowing cash from dealers and posting the newly purchased securities as collateral. When the dealers sell securities to the Fed, they receive cash, increasing the amount of dollars in the system. By borrowing that cash via repo, the Fed is sweeping it back out of the system.

This type of program allows the Fed to reduce long term rates (thus lower corporate borrowing costs and mortgage rates) by purchasing longer term securities (as it has been doing with Operation Twist). At the same time the Fed keeps the monetary base constant by sweeping out the cash it has put into the system. But this monetary strategy doesn't come for free. The Cash borrowed in the above diagram is typically a very short term loan, often just overnight.

With sufficient amount of sterilized purchases, the Fed will increase demand for short-term money as it keeps re-borrowing hundreds of billions each day. And that may raise short-term rates, possibly even the Fed Funds (unsecured) rate. Therefore lowering long-term rates in a sterilized fashion may end up raising short-term rates - there is no free lunch. It is therefore unlikely the Fed would employ such strategy in the amounts as large as QE2 or run it for a long time.

For more on Sterlized QE see these resources:

1. Wall Street Journal - 'Sterilized' Bond Buying an Option in Fed Arsenal 2. FT Alphaville - Goldman on Sterlized QE 3.  Forbes - Who Cares About Sterilization? The Fed Pretty Much Just Announced QE3 4. Sober Look - Fed's sterilized purchases will raise short term rates 5. The Market Oracle - Get Ready to be Disappointed With Sterilized QE3 6. Zer0Hedge - There is No Such Thing as Sterilized QE... The Fed is Going to Disappoint.

We will be previewing the FOMC live in our daily Market Intelligence Briefing on Tuesday. For information on special subscription rates for FXTimes briefings, click here.

Nick Nasad is a macro economist, market analyst, and educator; and one of the main contributors to  FXTimes - provider of Forex News, Analysis, Education, Videos, Charts, and other trading resources.

Information and opinions contained in this report are for educational purposes only and do not constitute an investment advice. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness. FXTimes will not accept liability for any loss of profit or damage which may arise directly, indirectly or consequently from use of or reliance on the trading set-ups or any accompanying chart analysis.