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Fed Keeping Powder Dry for Now but Could Take Action in Q2

The Fed is expected to hold its firepower for now and will probably not say much new after it meets Tuesday.

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But some Fed watchers say it is possible the Fed will act next quarter, to help the economy before the effects of fiscal tightening take hold next year.

“There’s all indications it’s going to be a quiet meeting. All the tea leaves point to April being the more interesting one,” said Pierpoint Securities chief economist Stephen Stanley.

April is when the Fed will issue its new economic forecast, and it could be then or June, when the Fed is likely to decide whether to pursue a third round of so-called “quantitative easing” or QE3.

What the Fed Fears

Pimco portfolio manager and strategist Tony Crescenzi said he expects the Fed eventually to do another round of easing, and it’s likely it would buy mortgage bonds to push interest rates lower, as Fed officials have publicly discussed.

“It’s going to be data dependent. The trajectory of the data is very good right now for employment, but other data needs to show improvement,” Crescenzi said. “Final demand and consumption trends are still subpar.”

The April time frame may also give the Fed enough economic data to persuade members to vote in favor of easing, but he thinks it’s more likely for the Fed to act later in the quarter.

“The odds are still pretty good that it happens eventually because the economy continues to face many headwinds...There’s a risk from what people call a ‘fiscal cliff.’ There’s over $500 billion of fiscal drag that the U.S. faces on Jan. 1, 2013,” he said.

Crescenzi was referring to the expiration of tax cuts and automatic implementation of budget cuts. He said it’s possible that Congress may not want to address these issues in an election year and will leave it for the next Congress to deal with in early 2013.

The full $525 billion equals 3.5 percent of GDP, but it’s more likely less than half of that will be the final number, Crescenzi said.

“The central banks of the world are carrying the weight of national governments that have very little ability to engage their balance sheets, to stimulate economic activity so it’s left to the central bankers,” he said, adding that globally there have been 75 easing moves in the past six months.

Nomura Americas Treasury strategist George Goncalves said the Fed is likely to anticipate the impact on the economy of next year’s fiscal tightening, and the potential for acrimony in Congress as it addresses the situation. “They (the Fed) could get ahead of the curve and do it in the summer, when there’s some pull back in data, some uncertainty,” he said.

Stanley said the Fed would probably not act after July, for fear of being seen as behaving politically ahead of the November presidential election.

Still Doing the Twist

The Fed holds its one day meeting against the unusual backdrop of improving employment reports but other spotty data readings that are leading to sluggish economic growth forecasts. Stanley said due to Friday’s trade numbers, he cut his first quarter GDP forecast to 1.3 percent.

“Over the past few years, they have really put very little emphasis on GDP stuff and mostly focused on the labor market... now the data has flipped and the labor market numbers are strong and the activity data is weak,” he said.

The Fed may say something in its Tuesday statement about ‘Operation Twist,’ a program under which it has been buying longer dated securities while selling the same amount of shorter dated securities in its portfolio. It is expected to continue that program until the scheduled end in June.

Crescenzi said the Fed is also likely to maintain the line in its statement that says it will regularly review the size and composition of its securities holdings and be prepared to adjust the size of the holdings as appropriate.

The Wall Street Journal has reported that the Fed may consider a modified QE, or sterilized version, in an effort to quiet program critics who worry it creates inflation . The Fed could still buy mortgage or Treasury securities, but tie up that money by borrowing it back for short periods at low rates.

What Else to Watch

While the Fed’s 2:15 p.m. EDT statement is expected to be a highlight of the trading day, traders are also watching the February retail sales report, expected at 8:30 a.m. Retail sales are expected to show a 1.1 percent gain, due to a jump in gasoline prices and improved auto sales. The NFIB small business survey is also released at 7:30 a.m. and business inventories are at 10 a.m.

The rise in gasoline prices is being watched closely for its impact on consumers and business, but also for its contribution to inflation, as too hot an inflationary environment would also keep the Fed on hold.

The inflation concerns could also creep into the bond market Tuesday, as the Treasury auctions $21 billion in 10-year notes.

Ward McCarthy, chief financial economist at Jefferies, said it would not be a surprise to see a sloppy auction “ahead of the FOMC meeting and ahead of some ugly inflation numbers.” Producer prices are reported Thursday, and consumer prices are reported Friday.

Stocks traded quietly Monday on extremely low volume, ahead of the Fed meeting. The roughly three billion shares made for the lowest volume of 2012. The Dow was up 37 at 12,959 and the S&P 500 was up less than a point to finish at 1,371. The Nasdaq was down 4 at 2,983.

The yield on the 10-year note fell slightly to 2.030 percent.

Oil prices fell nearly a percent to $106.34 per barrel, on worries about Chinese growth slowing. Natural gas lost another 2.4 percent to $2.2690 per million BTUs, on concerns about oversupply.

Follow Patti Domm on Twitter: @pattidomm

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  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

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  • Senior Producer at CNBC's Breaking News Desk.