At the Federal Open Market Committee’s meeting August 11 and 12, one should expect no meaningful changes in the Federal Reserve’s interest rate policy. Specifically, one might expect that the Fed will cite continued economic weakness and the absence of inflationary pressures as a justification for the following course of action:

(a)    The maintenance of the federal funds rate at its present low level of between 0 and 0.25 percent for an extended period of time;

(b)    The continuation of the announced program of quantitative easing with scheduled buying by the  Fed of up to $1.25 trillion in mortgage-backed securities and $300 billion in long-dated U.S. Treasuries; and,

(c)    The continued close monitoring of the size and the composition of the Fed’s balance sheet with a view to making adjustments to the Fed’s credit and liquidity programs as needed.

One might anticipate that the FOMC will indicate that it expects that the strong monetary and fiscal policy stimulus now being applied to the economy will result in a gradual economic recovery and that the risks to that recovery are now more evenly balanced. As to the inflation outlook, the FOMC is likely to draw attention to the continued weakness in the labor market that should keep inflation in check despite the recent run-up in international oil prices.

The FOMC can be expected to intimate that it has the necessary policy tools to implement an exit strategy from its extraordinary monetary policy easing when needed. However, it is likely to suggest that the present weakness in the U.S. economy makes the pursuit of such an exit policy premature at this stage.   

Among the economic indicators on which the FOMC will be focusing that are suggestive of the prospect of a gradual economic recovery and a low inflation environment are the following:

(a)    Second quarter GDP data providing the clearest of evidence that the pace of overall economic decline has dramatically slowed.

 


(b)    Purchasing managers’ data suggesting that manufacturers have started increasing production in order to rebuild depleted inventories.

 

(c)    Various housing market indicators suggesting that home prices might finally be in the process of bottoming out.
 

(d)    A variety of indicators suggesting that financial markets are presently healing, as indicated most clearly by an almost 50 percent run-up in equity prices from their March 2009 lows.

 

(e)    Household income data showing that wages and salaries are now declining at their fastest rate in the postwar period, and that household income could decline in the period ahead after being artificially boosted in the second quarter by the fiscal stimulus package.

 
(f)    Employment data pointing to continued substantial weakness in the labor market as underlined by an unemployment rate that is headed towards 10 percent.

 


(g)    Consumer confidence data suggesting that the consumer remains highly uncertain about the economic outlook.

 
(h)    Consumer price data showing that prices have been falling at their fastest pace in the postwar period and that there appears to be little short-term risk to inflation.

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.