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After QE3, Can the Fed Excite Markets This Week?

Tuesday, 23 Oct 2012 | 12:40 AM ET

Just because last month's Federal Reserve meeting came with some punch with the announcement of aggressive stimulus measures to boost the U.S. economy does not mean this month's meeting is any less important, Fed watchers say.

Given that the central bank pledged last month to keep supporting the economy via asset purchases until it sees significant improvements, the Fed's assessment of the economy is seen as key to judging just how long the latest round of quantitative easing will last.

"Markets will be watching to see how the Fed characterizes recent housing and unemployment data and there may be some discussion regarding what more the Fed could do if required," said Shane Oliver, head of investment strategy and chief economist with AMP Capital in Sydney. (Read More: Bernanke Defends Stimulus as China, Brazil Raise Concerns.)

The Fed said last month it would buy $40 billion in mortgage-backed securities every month until there is substantial improvement in the labor market, taking an unprecedented step to tie bond purchases to economic conditions. Unlike in its two previous bond-buying programs, the Fed said it would only purchase mortgage-backed securities, hoping in part to help a housing sector that Fed Chairman Ben Bernanke called "a missing piston" in the U.S. recovery.

By buying mortgage-linked debt, the Fed aims to press mortgage rates lower, helping the housing market and also encouraging investors in mortgage-backed securities to switch into other assets, such as corporate bonds, lowering their yields as well. (Read More: How Does the Fed Help My House, My Mortgage?)

Since the September meeting, there have been signs of improvement in both the housing and labor markets.

Housing starts, the number of new houses under construction, surged in September to its fastest pace in more than four years and beat Wall Street forecasts, a sign that the housing sector may be gaining traction and supporting the wider economic recovery.

The unemployment rate meanwhile fell to 7.8 percent in September, falling below 8 percent for the first time since January 2009, the lowest since President Barack Obama took office nearly four years ago, according to latest official data.

According to Vasu Menon, head of wealth management at OCBC Bank in Singapore, the Fed is likely to say that it will stay vigilant, despite the positive data, and be prepared to act if the economic outlook deteriorates.

"There's positive data, but the reality of the matter is ... data has been very volatile. I think the Fed knows it's not a firm recovery and that doesn't provide the Fed with a lot of comfort," he said. "They will likely say they will continue with the easy monetary policy and monitor developments."

Watch December

While the October meeting will be important for what the Fed says about the economy, the next meeting, scheduled for December, will be interesting in terms of any further policy moves, analysts said.

"They just made these bold steps in the form of QE3 (a third round of quantitative easing), so they can sit back and say, we're seeing how things are developing," Adolfo Laurenti, deputy chief economist and managing director of Mesirow Financial told CNBC Asia's "Squawk Box" on Tuesday. "I think the interesting step will come in December."

The December meeting will also follow the Nov. 6 presidential election and that may pave the way for more clarity on how the U.S. Congress plans to deal with the "fiscal cliff" of tax hikes and spending cuts that are due to kick in in January. (Read More: What Might Happen If Congress Actually Resolved 'Fiscal Cliff.')

"Even though it's on everyone's radar, we had other things to deal with throughout the year which had taken our eye off the ball a little bit. Now, it's very much back, front and center and in focus," Laura Fitzsimmons, vice president for futures and options at JPMorgan Investment Bank in Sydney told "Squawk Box." "We think that the payroll tax cuts are not likely to continue and therefore we expect this fiscal drag to be bigger than even we had forecast."

The U.S. Congressional Budget Office and the International Monetary Fund have said that if the fiscal tightening that is due to take place goes ahead without action from Congress, the U.S. economy will probably fall into recession. Economists peg the damage from the impending fiscal tightening as high as $720 billion, which will wipe off 4.6 percent from gross domestic product, effectively pushing the U.S into recession.

"The December (Fed) meeting may be more interesting, given the 'fiscal cliff,'" AMP's Oliver.

—By CNBC's Jean Chua

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