The Fed Sounds a Cautious Note on Recovery

At its June 23 policy meeting, the Federal Reserve picked up where it left off in late April, holding the line on policy and simply fine-tuning its statement to dovetail with the various, mostly negative developments in the interim. Caution on the recovery and patience on the policy front appeared to remain hand-in-hand following developments in European credit markets and the pullback in U.S. housing data of late, vindicating Chairman Ben Bernanke's stonewalling of the growing contingent of inflation hawks on the policy-setting Federal Open Market Committee.

In the end, Bernanke and the relatively silent dovish majority prevailed, and the 0 percent to 0.25 percent target zone on Fed funds was retained, along with the "extended" time horizon for "exceptionally" low interest rates. Kansas City Fed president Thomas Hoenig continued his hawkish protest against that view, being the only FOMC member to dissent from the June 23 policy statement.

There had been considerable speculation earlier in the year that the FOMC might start moving toward the exit with a shift in the policy statement by this meeting, including possible indications of asset sales. But with the heightening in the euro zone fiscal crisis since the FOMC's last policy meeting on April 27-28, along with tame inflation and uncertainties over the recovery, the Fed appears on hold through at least yearend, if not beyond. The Fed remained sanguine on inflation, adding that "prices of energy and other commodities have declined somewhat in recent months."

In terms of the economy, the statement was adjusted to reflect some speed bumps on the road to recovery. It altered the opening sentence as expected, swapping in the bland "economic recovery is proceeding" for the previous, bolder "economic activity has continued to strengthen." The Fed also said the labor market is "improving gradually," compared to "beginning to improve" in April. Housing starts remain " at a depressed level" was reiterated, but the Fed removed the out-of-date April aside that "housing starts have edged up," acknowledging recent weakness in that sector.

The Fed said financial conditions have become "less supportive, largely reflecting developments abroad." The Fed's addition of "less supportive" compared to April's "financial markets remain supportive of economic growth." Though household spending is "increasing," it is still being constrained by "high unemployment, modest income growth, lower housing wealth, and tight credit."

TALF talk eliminated

In terms of inflation, the Fed capitalized on some ample room for a deeper explanation with the addition of some explanation of lower energy and commodity prices in the inflation section. Specifically, it added the notation that "[p]rices of energy and other commodities have declined somewhat in recent months and underlying inflation has trended lower" to its boilerplate reference to slack resource utilization and restrained cost pressures. It would seem that the Fed's position on the sidelines at very low rate levels remains secure, as the core (excluding food and energy) indexes for U.S. producer and consumer prices have been extremely subdued for months.

The final paragraph referring to the schedule of the remaining TALF special liquidity facility was eliminated and the statement announcing the policy decision and offering of future guidance was essentially split into two parts as follows:

"The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

"The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability."

The economic data have not prompted the need for any wholesale changes in the Fed's outlook, though the housing outlook certainly weakened, given the 2.2 percent drop in May existing home sales and the 32.7 percent plunge in May new home sales, to a record low, this week. That data, along with a 10 percent dive in May housing starts, necessitated some tailoring of the view that housing had "edged up" from depressed levels, as the end of the home buyer tax credits ended in tears for the residential real estate market despite historically low mortgage rates and the traditional peak for selling in the Spring. Though a drop-back had been expected, the size of the post-April contraction has squashed hopes that the tax subsidy may have "primed the pump" to leave a virtuous cycle via employment, retail sales, gross domestic product, confidence, and so forth.

stocks and yields down, VIX up

True, the employment picture has improved modestly in 2010, but gains in nonfarm payrolls likely peaked in May, boosted by heavy federal hiring of census workers, which should post a 233,000 partial June reduction in census staffers, resulting in our forecast of a 140,000 drop in overall payrolls and an uptick in the jobless rate to 9.8 percent. Initial jobless claims have leveled out in the neighborhood of 460,000 after peaking at 643,000 in March 2009. Retail sales have pulled back following the 2.1 percent peak gain in March, with a 1.2 percent drop in May in the absence of incentives for appliance purchases, while consumer confidence has remained fragile, though above recession lows. Gross domestic product appears to have plateaued in the unimpressive 3 percent to 4 percent area, with 3.0 percent growth in the first quarter and a projected 3.6 percent clip in the second.

Market indicators since the conclusion of the last meeting on April 28 have taken some starch out of recovery hopes. Stocks deteriorated, with the Standard & Poor's 500-stock index stalling out above 1200 at the time of the last meeting, and marking lows of 1041 on May 25, before recovering above 1090, below its 200-day moving average near 1111. The 10-year Treasury note yield slumped from the 3.75 percent area at the last meeting, to 3.11 percent currently, as the strains on the European financial system and fresh declines on U.S. housing weighed. The two-year yield tanked from 1.04 percent, to slip under 0.68 percent, as the Fed was correctly anticipated to be back on hold rather than chomping at the bit to raise rates.

The VIX equity volatility index ramped up, from the 22.0 area in late April, to clear 45.0 in May, and then settle back down to the 27.0 area currently, still elevated. Risk- and fiscal-proxy gold rallied from around $1,170 per ounce, to a record high of $1,265 on June 21, before stalling, clearly still pricing in global fiscal angst and hedging against further financial and economic consequences. The U.S. dollar index has rallied smartly, from the 81.0 area, to a high near 88.7 in early June, before settling under 86.0 on June 23, another sign of increasing risk aversion.

Fed funds futures inched up on the Fed's statement on June 23, in tandem with further gains in Treasuries, as the FOMC downgraded its economic outlook slightly, while noting that "underlying inflation has trended lower." Those factors are being seen as reflecting a fractionally more dovish policy stance and support market expectations that the FOMC will be on hold with 0 percent to 0.25 percent rates through yearend. Many in the market are pricing in a steady Fed stance through 2011 as well.

The Fed exercised its right to "monitor the economic outlook and financial developments" on June 23 and accordingly toned down its outlook on growth and inflation. Should the markets continue to find this a credible policy position, rather than an untenable one, the Fed will maintain its exceptionally accommodative posture for a longer period than previously implied, and certainly through the next meeting in August.