Friday, April 30, 2010

Fed opts for gentle touch on interest rates

It says economy is getting better but decides to keep rates low for extended period

IT was a message awash with hope and a surprisingly gentle punchline.

The employment market is improving, household spending is on the rise, business investment is picking up, the Federal Reserve's interest rate policymaking committee said on Wednesday. Despite this, the Federal Open Market Committee's stance on keeping short-term interest rates near zero for an 'extended period' remains unchanged.

The decision to peg the key federal funds rate in the range of 0 per cent to 0.25 per cent - where it stays - was initially taken more than a year ago, at a time when the financial crisis was running at fever pitch and the US economy appeared in imminent danger of plunging into its first depression since the 1930s.

The FOMC's decision to leave unchanged its promise to keep interest rates low 'for an extended period', brought to a somewhat surprising end weeks of speculation on Wall Street that the April meeting would mark the unofficial beginning of a period in which the Fed will begin to prepare investors for an eventual rate hike off its current historic low levels with an alteration or modification of some sort of the much-invoked phrase.

Steady improvement in economic data and minutes from the March FOMC meeting, which was marked by a steady chorus of dissent and debate among the committee's voting members regarding the need to keep interest rates so low, had investors braced for a new signal on how the central bank will begin pulling liquidity from the system.

'The betting was that we would get an upgrade on the committee's outlook on the economy, and along with that a downgrade on its belief that interest rates need to be kept at nearly zero without a change in the Fed's policy stance even on the horizon,' said Max Bublitz, the chief market strategist at San Francisco, California-based SCM Advisors, which manages over US$3.5 billion in institutional and private assets. 'Instead what we got from the Fed was a kind of a yawner of a statement,' he observed.

'While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the committee anticipates a gradual return to higher levels of resource utilisation in a context of price stability,' the FOMC said, using new, more optimistic language on the economy and pointing to improvements in various economic sectors at the beginning of its statement.

The key portion of its commentary, on its intentions, however, could have been lifted from any of the FOMC's policy meeting statements of the past several months:

The committee 'continues to anticipate that economic conditions, including low rates of resource utilisation, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. The committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.'

The Federal Reserve Board's mostly unchanged statement had a welcome calming effect on Wednesday on a stock market still feeling jolted by the unravelling of attempts to fix Greece's debt woes and the ripple effect those attempts are having on the value of the euro and the sovereign debt of first Portugal and now Spain, which on Wednesday saw its debt rating downgraded by S&P.

Stocks ticked higher after the Fed left interest rates unchanged and kept the 'extended period' language in its statement, turning a morning of losses into an afternoon of gains.

The Dow Jones Industrials finished with a gain of 53 points, or 0.5 per cent, to 11,045.27.

The S&P 500 gained eight points, or 0.7 per cent, to 1,191.36, while the Nasdaq Composite edged up by only a fraction of a point, or 0.01 per cent, at 2,471.73.

Debate over the merits of and the reasons for the Federal Reserve's willingness to maintain the 'extended period' language, despite strengthening in economic activity began almost immediately.

Some market strategists argued the Fed might feel handcuffed by the turmoil coming out of Europe's sovereign debt crisis, while others said the Fed might actually be hoping to see some inflation enter the economy as a way to raise values of the mountain of distressed assets still weighing on banks, which remain reluctant to lend.

'If they don't get their act together soon and start raising rates, it's not going to be too bullish when we have all this debt to refinance and the dollar keeps on weakening,' said Dave Rovelli, managing director of equity trading at Canaccord Addams.

Mr Bublitz agreed that looking longer-term, the Fed's willingness to keep rates so low could weigh on the economy and the financial markets in various ways. 'But bottom line is that for now, the Fed is keeping intact the basis for the 13-month-long rally, and that's obviously bullish for risk assets,' he said.

Source: Business Times, 30 Apr 2010

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