At its scheduled meeting this week, the Federal Open Market Committee is likely to pause for breath. It will do so following the dramatic announcement at its previous meeting that the Federal Reserve would expand its balance sheet by around US$1.1 trillion in an effort to shore up the flagging U.S. economy. On this basis, one should not expect new policy initiatives at this meeting. Rather, one should expect that the FOMC will reiterate its commitment to maintain the federal funds rate at between 0 and 0.25 percent for an extended period, and its plan to continue its program of purchasing large amounts of mortgage-backed securities and U.S. treasuries.

The FOMC will make its decision to effectively keep policy on hold against the backdrop of tentative indications that the pace of economic decline is substantially abating and that the downside risks to the U.S. economy have appreciably diminished. However, the FOMC will remain mindful that the U.S. financial system remains fragile, that households are in the process of trying to repair eroded balance sheet positions, and that the international economy continues to deteriorate.

On the question of inflation, the FOMC is likely to indicate that it expects that inflation will continue to decline over the next year as a result of very large gaps in domestic product and labor markets. However, one should expect that the FOMC will intimate that it is keenly aware of the longer-run risks to the inflation outlook posed by the presently highly accommodative stance of both monetary and fiscal policy. It is also likely to indicate that it is already thinking of an exit from today’s extraordinary monetary policy easing.

Among the key economic indicators that will be informing the FOMC’s decision are the following:

(a)    The state of the labor market continues to deteriorate. Over the past five months, the U.S. economy has been losing around 600,000 jobs a month, while the unemployment rate has now risen to 8.5 percent.

(b)   Weekly jobless claims remain at very elevated levels, which would be consistent with unemployment rising to at least 9.5 percent by year end, which would be well above the Federal Reserve’s unemployment forecast of 8.3 percent to 8.8 percent in 2009.

(c)    Retail sales are now showing some sign of stabilization although they are doing so at levels which are substantially below those of a year earlier. This stabilization would be consistent with the overall economy continuing to decline in this second quarter of 2009 but at a markedly slower pace than over the past two quarters.

(d)   Consumer confidence appears to have stabilized but it has done so at a historically low level. This would be consistent with a gradual stabilization of the overall economy.

(e)    Housing starts appear to have finally bottomed albeit at a very low level. The fact that housing construction is no longer contracting should remove a major headwind from economic recovery.

(f)    Financial markets appear to be stabilizing as suggested by a 20 percent run-up in equity prices from the low levels recorded in early March 2009.

(g)   The overall consumer price index has declined on a 12-month basis for the first time in over 50 years. Excluding food and energy prices, consumer prices are 1.8 percent higher than they were a year ago, which is well within the Federal Reserve’s comfort zone. The Federal Reserve will expect that inflation will decelerate further in 2009 as a result of the large gaps that now characterize the labor and product markets.

Desmond Lachman is a resident fellow at the American Enterprise Institute. Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney.

FURTHER READING: Lachman also wrote “The Next Economic Shoes to Drop” on what further strains on the financial systemto expect in 2009, and “Don’t Repeat Japan’s Mistakes” on  the Japanese authorities mishandling of their own financial crisis during the early 1990s. Go here to see Lachman’s presentation on the housing market bottom.

Image by Darren Wamboldt/The Bergman Group.