Fed Will Try to Assure Markets As It Cuts Economic Forecast

The Federal Reserve is likely to cut its view of economic growth, making it more difficult for Fed Chairman Ben Bernanke to assure markets that the second half of 2011 will be better than the first half.

Ben Bernanke
Ben Bernanke

The Fed winds down its two-day meeting Wednesday, followed by a post-meeting statement at 12:30 p.m. and economic forecast at 2 p.m.

Fed Chairman Ben Bernanke will then hold a press conference at 2:15 p.m., which will be carried live on CNBC.com.

The meeting comes just a week before the Fed is scheduled to retire one of its most controversial programs. Fed watchers expect no change in plans to curtail the quantitative easing program (QE2) June 30, nor do they expect the Fed to discuss another round of easing.

What they are watching is what the Fed says about the economy as the jobs picture remains weak and growth has stalled.

"This idea that the slowdown is transitory is the dominant theme. You've seen it in the commentary, even from the doves," said Tony Crescenzi, senior market strategist at Pimco.

He expects the Fed to trim its 2011 growth forecastto less than 3 percent from its current range of 3.1 to 3.3 percent.

J.P. Morgan economist Michael Feroli said he expects the Fed to mark down growth for 2011 just because of the sluggish second quarter. He notes that Fed officials have said they expect to see a pickup to 3 to 3.5 percent growth in the second half.

The Fed last lowered its 2011 growth forecast in April. GDP grew just 1.8 percent in the first quarter, down from the 3.1 percent pace of the fourth quarter. Many economists see the current quarter at less than 3 percent, and some are closer to 2 percent.

Feroli said he would like to hear the Fed chairman answer questions about the second half, which is when many economists see the economy reaccelerating. "What changes their mind on the second-half rebound?" he said. "What would they have to see that alters that view?"

Bernanke is expected to be more downbeat than at his last briefing. Goldman Sachs economists expect him to deliver the message that there are temporary factors affecting growth, but he should also acknowledge a broader lack of momentum. They expect the Fed to trim its growth forecast to about 2.7 percent for 2011.

Bernanke is also expected to be asked about the fiscal struggles in Greece, which have ironically sent U.S. interest rates to lower levels than the Fed's QE2 program was able to as buyers rushed to the safety of Treasurys.

Crescenzi said there are signs that some of the factors that caused the slowdown are reversing and that should help the economy in the second half. One of those was the hit to auto production, due to the supply chain issues resulting from the Japanese earthquake and tsunami.

Another factor that hurt the economy was the sharp jump in oil and gasoline prices, which are now falling. The AAA national average price of gasoline — $3.62 per gallon — is down about 10 percent from May's high, but it is still about $0.90 above the level a year ago.

Citigroup economist Steve Wieting said production is already improving at the Japanese-owned auto plants in the U.S.

"I think the one thing we can be clear about is there was economic impact in the last several months, plenty of signs of it, from the Japanese earthquake," he said. "We're seeing early, very significant signs of recovery form the supply chain disruption already.

"Just the decline in Japanese-brand sales and the production declines was probably responsible for a drag of 1 percent in the second quarter," he said.

Wieting said car and light production at Japanese-brand auto plants rebounded 95 percent in the past two weeks, following a trough in the first week of June. The level in the week ending June 18 was 79 percent of the level it was in March, before the earthquake.

But the auto shutdown is just one factor. "There are open-ended questions if the slowdown is entirely this or more," said Wieting.

The Fed, therefore, should not make any moves or signals that it is ready to exit any of its other programs. It currently has interest rates at zero.

As the $600 billion QE2 Treasury purchase program ends, it will continue to make smaller Treasury purchases totaling about $25 billion a month to replace its mortgage holdings as they roll down.

"They're in no hurry for exit strategies," Wieting said. "The weakness in the employment data sort of resets the bar for anyone thinking we had a need for near-term exit."

Crescenzi said any discussion of a third quantitative easing program is at least a quarter away and would mean the economy continues to be sluggish or weaken.

"One of the things they are doing in halting QE is adjusting the downside risk from some of the imbalances that could be created by a long period of low interest rates," he said. "There could be too much dependence by banks and large financial institutions on easy credit and low rates."

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