Fed Likely to Hold Rates Low to Support Fragile Recovery

June 21, 2010

Veronica Smith

The US Federal Reserve meets this week to determine monetary policy aimed at supporting a fragile economic recovery allowing little room for maneuver to change ultra-low interest rates.

The Federal Open Market Committee opens a two-day meeting Tuesday widely expected to leave its target federal funds rate between zero and 0.25 percent, where it has been since December 2008.

All eyes in the financial markets will be on the FOMC statement to be released after the meeting Wednesday.

The central bank policymakers were not expected to deviate from their now-customary language that economic conditions "are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

But investors and analysts will comb over the text to try to determine the direction of policy and the central bank's outlook on the world's largest economy.

"We expect the FOMC to keep a steady hand on the helm at the June 22-23 meeting with no surprises -- the Fed will vote to keep the target rate unchanged in the range of 0.0 percent to 0.25 percent, while the 'exceptionally low for an extended period' language will be retained," said IHS Global Insight analysts Brian Bethune and Nigel Gault.

"Arguments in favor of departing from this strategy in the near future have weakened substantially over the past two months," they said in a note to clients.

Since the last rates-setting meeting on April 27-28, mixed economic reports have underlined the economy's struggles to emerge from the recession that started in December 2007, the worst downturn since the 1930s Great Depression.

New US housing construction slumped in May to the lowest level this year, renewing concerns about the embattled sector that was the epicenter of the global financial crisis.

"With housing contributing so little to the economic recovery, the economy is growing more slowly than normal at this point in the economic cycle. This slow recovery keeps unemployment high but it also keeps inflation low," said Gary Thayer, chief macro strategist at Wells Fargo Advisors.

Manufacturing, which has led the recovery that emerged in mid-2009, has seen growth slow, according to the East Coast regional indices released last week by the Fed's New York and Philadelphia banks.

Unemployment near 10 percent remains a key challenge to recovery while helping to keep inflation at bay, removing pressure on the Fed to raise interest rates to prevent the healing economy from overheating.

Fed chairman Ben Bernanke told lawmakers last week that the economy was on track to grow 3.5 percent this year and would see only a "modest" impact from the eurozone debt crisis.

"The economy... appears to be on track to continue to expand through this year and next," he said in testimony to Congress.

Brian O'Hare, chief market analyst at Briefing Research, predicted the Fed would use other measures in its toolbox to tighten monetary policy before turning to interest rates.

"This is a delicate balancing act," O'Hare said.

"More than likely... it will begin a tightening cycle with alternative measures first to reduce the money supply as it attempts to artfully keep inflation pressures, and inflation expectations, in check," said O'Hare.

"The fed funds rate may be held near the zero bound for quite some time in a defensive move aimed at helping to promote maximum sustainable employment."

Gregory Drahuschak, a Janney market strategist, said the FOMC statement could provide a jolt of new confidence in the strength of the recovery.

"Recently Fed reports have tended to confirm that the economy is improving albeit slowly. A reaffirmation of this in the normally carefully crafted language of the policy statement could allay fears that the economy might slow too much," he said.

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