With America still in a defensive crouch after a crushing recession and financial meltdown, the U.S. Federal Reserve is unlikely to soften its promise of rock bottom interest rates soon.
Nascent signs of recovery have been stacking up and financial markets will be watching next week's Fed policy-setting meeting for any hint the central bank is moving closer to withdrawing its extensive support for the economy.
But with unemployment expected to go above 10 percent and factory capacity use near post-World War Two lows, there is doubt whether the economy can stand on its own feet after generous government spending programs and tax breaks dry up.
The difficult conditions in labor markets and the consequent implications for household incomes are important reasons for my expectation that the recovery in overall economic activity moving into next year will be restrained, Fed Vice Chairman Donald Kohn said two weeks ago.
The Fed chopped interest rates to near zero in December. On top of that it has flooded the financial system with hundreds of billions of dollars to pull the economy out of the worst financial crisis and most painful recession in decades.
Initially, it said it anticipated exceptionally low interest rates for some time. In March, it deepened that commitment to an extended period -- a pledge it has repeated in every Federal Open Market Committee statement since then.
The committee ... continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period, the policy panel said after its last meeting on September 22-23.
The phrase is a critical piece of a statement that officials could dial back to prepare markets for tighter money.
However, officials are still nervous about the recovery and appear likely to conclude at their meeting on Tuesday and Wednesday that tinkering now would send a premature signal.
If you do discuss it now, the genie's out of the bottle in terms of expectations, the market would start pricing in expectations of a sooner tightening, said former Fed economist Antulio Bomfim, now with forecasting firm Macroeconomic Advisers. The hurdle is high enough for even approaching the topic in the meeting, much less making a formal decision for changing the language.
Indeed, a Financial Times story on Friday saying officials were considering softening the pledge fueled speculation that a rate hike was closer at hand than previously thought.
By Monday, interest-rate futures prices implied a rate increase would come in the second quarter of 2010, with borrowing costs hitting 1.25 percent by the year end, although those bets started to come off a bit on Tuesday. Previously, the first hike was seen coming in the third quarter.
While shifting the language would give more flexibility to the Fed's policy-making, top brass have yet to offer any public signal that they plan to alter the rate pledge, a step they would likely take to prepare the markets for any shift.
Fed Chairman Ben Bernanke said on October 8 that accommodative policies would be warranted for an extended period, while Vice Chairman Donald Kohn reminded an audience of the commitment to unusually low levels of interest rates for an extended period in his October 13 speech.
The language means that to heal the economy of its grave wounds, policy-makers will keep interest rates low even as an economic recovery builds, analysts said.
This is meant to ward off the view that as soon as growth picks up, the Fed is going to tighten, said Dean Maki, a former Fed economist who is now chief U.S. economist at Barclays Capital.
Both Bernanke and Kohn have said in recent weeks they expect the U.S. recovery to be tepid. A number of Fed officials have said they will be ready to pull back support for the economy when the time is right, but that just because they are talking about it doesn't mean they're about to do it.
The New York Fed last week sought to tamp down market anticipation of tightening moves by issuing a statement saying that trial runs of a tool to help the central bank raise interest rates were a test of its capacities, not a signal that a tightening was set to begin.
Also, minutes of the Fed's September meeting showed some policy-makers were sufficiently nervous about the recovery to consider expanding purchases of longer-term securities to provide an additional prop.
To be sure, softening the pledge language would give the Fed a freer hand should economic conditions brighten faster than expected. And with interest rates near zero, an increase of one or two percentage points would still keep rates in accommodative territory.
The question is whether that flexibility is worth confusing the market, Barclay's Maki said.
In the past, the Fed has left ample room between the end of a recession and rate hikes, moving only well after unemployment had peaked.
When the last recession ended in November 2001, the first rate hike was not until June 2004 -- 31 months later. In the previous recession, the Fed raised rates in February 1994, 35 months after the recession ended in March 1991.