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Fed officials to mull much, change little at July meeting

A view shows an eagle sculpture on Federal Reserve building in Washington August 22, 2012. REUTERS/Larry Downing
A view shows an eagle sculpture on Federal Reserve building in Washington August 22, 2012. REUTERS/Larry Downing

By Ann Saphir

(Reuters) - Federal Reserve officials this week are likely to have a lively debate on how best to prepare financial markets for a reduction of their bond-buying program, but appear certain to wait for further economic data before curtailing their stimulus.

While the debate will not produce much in the way of policy change, officials may tweak their post-meeting statement to lay the groundwork for paring their $85 billion-a-month bond purchase program as early as September. The Fed releases its post-meeting statement at 2 p.m on Wednesday.

"They may hint that some tapering is likely if the economy continues to grow," said Eaton Vance portfolio manager Eric Stein, noting that Fed Chairman Ben Bernanke already laid out a timeline for ending the purchases by mid-2014 at a news conference after the Fed's last meeting held June 18-19.

When bond yields surged after Bernanke's remarks, the chairman and other Fed officials turned out in force to convince markets that drawing the bond buying to a close does not mean that their support for the economy would disappear, given the central bank's already bloated balance sheet and their intention to hold interest rates at zero for a long time to come.

They had some success re-anchoring rate expectations. Futures markets are pricing in a first rate hike no sooner than January 2015. They had been betting on a hike as early as October 2014, earlier than all but four of the Fed's 19 policymakers see as appropriate.

With traders ready to drag market rates sharply higher at any hint of tighter policy, investors will mine any changes in the central bank's post-meeting statement to gauge how closely the pace of recovery is tracking the Fed's own expectations, a key metric for judging if the central bank will go through with its plan to pare its bond buying later this year.

A government report on Wednesday is expected to show economic growth weakened in the second quarter, but a separate report on Friday is expected to show the unemployment rate ticked down in July to 7.5 percent from 7.6 percent in June.

"Acknowledging the recent weakness in GDP growth would be seen as dovish, unless the (Fed) tags it as temporary," Bank of America-Merrill Lynch senior U.S. economist Michael Hanson wrote in a research note. "The strongest message would likely be an indication that the (Fed) sees significant cumulative improvement in the labor market outlook."

At the two-day meeting, which kicks off on Tuesday, officials will weigh a change to their forward guidance on rates - as Minneapolis Fed chief Narayana Kocherlakota has urged - and a stronger assurance on their commitment to fight low inflation - as St. Louis Fed President James Bullard has wanted.

The Fed cut its overnight rate to near zero in December 2008 and it has more than tripled its balance sheet to $3.53 trillion through a series of bond purchases meant to hold down longer-term borrowing costs.

On overnight rates, it will keep them near zero until unemployment falls to at least 6.5 percent, as long as inflation stays in check.

Some officials, including Kansas City Fed President Esther George, will continue to press for paring bond-buying sooner than later. Others, including Chicago Fed President Charles Evans, will likely call for more data before dialing stimulus down.

In the end, most economists feel the Fed will stick to the timeline Bernanke laid out, despite the economy's current weakness. Bernanke told Congress two weeks ago that data since June had been mixed and it was "way too early" to prompt the central bank to delay plans to pare back bond-buying.

A flurry of speculation last week on potential successors to Bernanke may also weigh on policymakers who are conscious of the limited time left for adjusting policies under current leadership. Bernanke's term ends in January, and he is widely expected to step down.

That pressure could nudge the committee towards action a bit faster than otherwise, according to Eaton Vance's Stein.

"I do think the fact that there will be a new chairman does affect" the Fed's deliberations, he said. By shaping a clearer policy course sooner, he said, Fed officials in effect may be saying, "let's make the job of (Bernanke's) successor a little bit easier."

(Reporting by Ann Saphir in Chicago; Editing by Tim Dobbyn)

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