Crescenzi: FOMC Preview; Three Focal Points

For Tuesday’s FOMC meeting, market participants are likely to focus on three issues in particular:

  • Whether the Federal Reserve has reduced its 2011 economic forecast
  • The trigger that would spur additional monetary easing by the Fed
  • The specific actions the Fed might take

Let’s look at these.

United States Federal Reserve
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United States Federal Reserve

The Federal Reserve’s relatively sanguine economic forecast has been in focus because the forecast suggests the bar for additional monetary easing is high.

A change in the forecast is therefore seen as a prerequisite for any change in policy.

In June, Federal Reserve governors and Reserve Bank presidents forecast economic growth of 3.5 to 4.2 percent in 2011. Although Federal Reserve Chairman Ben Bernanke reaffirmed the largely sanguine view about 2011 when he spoke on August 27th in Jackson Hole, Wyoming, he said that “the pace of economic growth recently appears somewhat less vigorous than we expected.”This suggests that the Fed’s projections for the pace of economic growth in 2011 are likely to be lowered.

Market participants will look for clues in the policy statement to any changes that might have occurred. Specifics will follow in three weeks in the minutes written for tomorrow’s meeting.

The trigger that would spur additional monetary easing by the Fed is easier to predict than the actual policy response because the trigger for any easing of monetary policy tends to be related to deterioration in the labor market combined with a downturn in industrial output.

These are the two conditions associated with economic recessions.

The magnitude of any Fed response that may evolve is more difficult to judge.

In the past, the Fed could equate a specific rate-cut amount (for example, a 25 basis point cut), to a specific set of transmission effects. In other words, for a given change in interest rates, the Fed was able to make judgments about how the rate cut would transmit to the economy through the financial markets, in particular via market interest rates, stock prices, corporate bond yields, and the value of the U.S. dollar. Through these transmission channels the Fed could judge the effects of its cuts on the economy.

These days, the amount of impact that can be expected from the Fed’s actions is more difficult to judge—the direction of impact is much easier to judge than the magnitude.

This makes sizing any QE difficult for the Fed.

Tony Crescenzi is Senior VP, Strategist, Portfolio Manager Pimco. Crescenzi makes regular appearances on financial television stations such as CNBC and Bloomberg, and is frequently quoted across the news media. He is also the author of "Investing from the Top Down," "The Strategic Bond Investor," and co-author of the 1200-page book "The Money Market."