The Federal Open Market Committee (FOMC) will meet on September 22nd and 23rd.The FOMC interest rate decision and policy statement will be released on September 23rd. The FOMC is widely expected to leave the Fed funds rate target unchanged at 0.00%-0.25% and to maintain the current level of bond purchases through October. The trade will be looking to see whether the FOMC signals that it is ready to end quantitative ease. The trade will also be looking to see whether the Fed lays the foundation for withdrawal of stimulus and sets the stage for future interest rate hikes. There is speculation that the FOMC may begin to signal a withdrawal of stimulus and possibly take a hawkish bias as recent US economic data points to end of the recession. Because the US recovery is likely to be weak we think stimulus withdrawal speculation is pre-mature.

FOMC may let bond purchases expire in October

In March, the FOMC announced quantitative ease and a plan to buy the $300 bln in US treasuries over a six month timeframe. The bond purchase plan was to expire in September. At the August policy meeting the FOMC extended the bond purchase plan through October. The trade expects the FOMC to let the bond purchase plan expire in October. This would signal the start of an exit strategy from quantitative ease. If the FOMC lets the bond purchase plan expire bond yields may start to rise. This could be a mild positive for the USD. There is an article in today's Wall Street Journal which talks about the fact that the combination of US household, bank and Fed purchases have fueled a bond rally and yields have not been rising as one would normally expect as the economy shows signs of recovery. The end of the FOMC bond purchase plan would take away a major source of support for the bond market and confirm the FOMC is preparing to exit quantitative ease.

FOMC may signal a coming shift in policy bias

Last week Fed Chairman Bernanke indicated that he believes the US recession has likely ended. Bernanke's comments coupled with recent US economic data that have beat expectations may encourage the FOMC to begin to gradually withdraw liquidity. Recent Fed policy statements have included the language that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. The trade will be looking to see if the Fed injects new language which limits the timeframe for the low level of interest rates. Dropping the extended period would be the first step toward signaling the end of the Fed's ease cycle.

Washington-based think tank suggests the Fed is divided

A Washington-based think tank Medley Global Advisors says that the FOMC is divided over how quickly to raise interest rates once the economic recovery is sustainable. According to the Medley report two FOMC members would support hiking rates at this week's FOMC meeting and a number of Fed officials are discussing the need to end quantitative ease. The Fed's Fisher says that winding down of the lending programs will need to be taken as soon as possible once the recovery shows convincing signs of traction. The Fed's Evans says that the Fed will want to be more aggressive in tightening than in  2004. Evans went on to say that this he does not envision the Fed moving on rates until sometime down the road with the economic recovery still in its early stages. The FOMC is unlikely to take action that would prematurely choke of the recovery. Note in the graph below how slowly the Fed moved to tighten policy in early 2004. 

 

Fed gains confidence in the recovery but recovery not yet sustainable

According to the August FOMC minutes most of the Fed board members see only a slow recovery during second half of 2009 and that the economy remains vulnerable to shocks. The pace of the recovery is expected to pick up in H2 2009 and into 2010. FOMC members disagree on the strength of the upturn. Fed board members remain concerned about jobs and warned that the need for labor reallocation could slow the recovery. Households face considerable headwinds because of reduced wealth and high debt. The FOMC has gained confidence that the downturn is ending and downside risks are smaller. The FOMC is unlikely to vote to hike interest rates at the September policy meeting because there is not enough evidence the recovery is sustainable.

Conclusion

Expect the Fed to let the purchase of treasuries expire in October and reaffirm that economic conditions likely warrant exceptionally low levels of federal funds rate for an extended period. The FOMC still has questions about the recent recovery and rate hikes remain far off. According to a Bloomberg survey of 91 economists all 91 expect the FOMC to maintain overnight rates at the current level. If the FOMC decides not to expand its bond purchase plan and lets the purchase plan expire it would be a mild positive for the USD. If the Fed signals a shift in bias and a timeframe for withdrawal of stimulus the USD will experience a more significant rally. Most of the trade expects the FOMC to leave monetary policy unchanged for the remainder of 2009 and to not begin to tighten policy until mid 2010. The trade will be looking at the September FOMC policy statement for clues to timing of future Fed rate hikes. Look for monetary tightening to begin in mid-2010. A slow tightening of policy is expected with Fed funds rate to rise to 0.50% by May of 2010 and 1% in October 2010 with rates rising to 2% by May of 2011. Note in the graph below that the Fed tends to make gradual policy changes at the end of recession.