Expect the Federal Reserve to deploy some kind of stimulus measure today. If policy makers opt against it, investors will make them pay.
U.S. stock markets rose to their highest level in more than a month Tuesday, mostly on anticipation that Fed chairman Ben Bernanke's policy committee will seek to counter a deteriorating economy. Failure to do so would risk unleashing volatility that Mr. Bernanke likely wants to avoid amid heightened anxiety over the European debt crisis.
"Should they do nothing, they will see the tantrums of a market in the throes of severe withdrawals," Sebastien Galy, an economist at Société Générale, wrote in a note for clients.
It's not that Mr. Bernanke is letting Wall Street pull him around by the nose. He set the stage for looser policy two weeks ago when he told a congressional committee that Fed policy would be dictated by the annual economic growth rate, which must be faster than two per cent to lower the unemployment rate.
"Generally, in that short time span, the backdrop has deteriorated," Tom Porcelli, chief U.S. economist at Royal Bank of Canada in New York, said in a research note. "As a result, come Wednesday, we expect the Fed to provide some market friendly signal."
The U.S. economy slowed from that pace in the first quarter, and economic indicators have been mostly weak lately. A report Tuesday by the Labour Department showed job openings fell by 325,000 to 3.42 million in April, the biggest one-month decline in almost four years. The unemployment rate was 8.2 per cent in May, compared with the Fed's goal of something closer to 5.5 per dent. Recent reports show retail sales, factory production and consumer confidence all are slumping.
Later today, the Fed will release an updated economic forecast. The current outlook is less than two months old, so it likely won't change dramatically. But the headwinds facing the U.S. economy clearly are getting stronger.
The Fed's forecast is based on the outlooks of the seven members of the Washington-based Federal Reserve Board and the 12 regional Fed presidents. The central bank discards the three highest and three lowest estimates to come up with the "central tendency." As this analysis by the Council on Foreign Relations' Center for Geoeconomic Studies shows, the unemployment rate is now running at a higher rate than the most pessimistic estimate in the central tendency.
The Fed's policy committee is scheduled to release a statement on its two-day deliberations at 12:30 p.m. Washington time. (The Fed will release its updated forecast at 2 p.m. and Mr. Bernanke is scheduled to hold a press conference at 2:15 p.m.)
While there is a consensus that the Fed will have something to say, Wall Street analysts are less certain about what the message will be. Some investors want to see a third round of quantitative easing, which would see the Fed create hundreds of billions of dollars to buy financial assets.
That's possible, but unlikely. In his testimony this month, Mr. Bernanke expressed some doubt about the efficacy of further QE, and the program is extremely unpopular with some investors and lawmakers because they fear it will create inflation. And as Mr. Porcelli points out, the reason to "go nuclear" is to stoke equity markets – which currently are doing ok.
More probable is an extension of existing policy measures. The Fed could opt to continue selling from its supply of shorter dated assets, and using the proceeds to buy bonds with longer maturities. (This lowers longer term interest rates.) Policy makers could also choose to lengthen their conditional commitment to keeping the benchmark interest rate near zero. Their current pledge is to do so until at least the end of 2014.