Fed May Not Be So Forceful on Rates

The market will be looking for further rate-hike clues in Tuesday's FOMC meeting.
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The

Federal Reserve's

communique Tuesday could prove to be more dovish than many investors expect.

Financial markets generally believe the Fed will lay the groundwork for an interest rate hike Tuesday by saying deflation fears have subsided and that the job market has picked up steam. But the central bank also is likely to suggest, as it has in prior statements, that a boost in rates isn't imminent.

"The Fed has to perform a high-wire act here between signaling to the markets that it sees deflation risks abating, but that it does not see broadly based inflation pressure either," said David Rosenberg, chief economist at Merrill Lynch. "It also has to show how all this fits in with the need at some point down the road to normalize interest rates -- but that they may not be in a big hurry to do so."

The fed funds rate currently stands at 1% and isn't expected to be adjusted at Tuesday's meeting. But most analysts say there will be some significant changes to the policy statement.

At the last meeting in March, the Fed said the risks of disinflation (or declining inflation) were almost equal to the risks of rising inflation and it noted that new hiring has lagged. After a jump in the most recent consumer price index and a much larger-than-expected increase in nonfarm payrolls in March, economists think the Fed will shift to a neutral stance on inflation and be more upbeat on the job market. It's not expected to change its assessment of economic growth, which is already balanced.

Becoming Less 'Patient'

Many pundits also expect the Fed to drop its intention to remain, in its own words, "patient" in raising rates. According to

Bloomberg

, 17 out of 23 primary dealers expect the Fed to omit the word from its missive on Tuesday.

"The 'patient' language probably goes, but it's not a slam dunk," said Ed McKelvey, senior economist at Goldman Sachs. "I think you will walk away from this statement saying, 'The Fed is thinking about when and under what conditions it tightens, but it's not imminent.'"

McKelvey, who isn't expecting the central bank to raise rates this year, said while the jobs report was strong in March, the labor participation rate has been extremely low, suggesting there could be some hidden unemployment.

Meanwhile, Rosenberg noted that more than half the jobs created in March were due to one-time factors such as unusually warm weather and an early Easter. He expects the Fed to voice concern about labor market slack as well as sluggish organic wage and salary growth Tuesday. Fed Chief Alan Greenspan already raised these issues in his testimony before the Joint Economic Committee in April.

"There is almost no momentum at all in real personal disposable income going into the second quarter," Rosenberg said. "Price increases are squeezing purchasing power, which then calls into question the ability to make them stick or certainly whether they'll be repeated."

Although headline economic numbers have generally been strong in recent weeks, Rosenberg pointed out that consumer spending has been weak given the $27 billion in tax relief, a near-tripling in mortgage refinancings and average payroll gains of 170,000 in the first quarter.

Time to Stay Neutral

Bruce Kasman, chief economist at J.P. Morgan, said if the Fed omits the word "patient" from its statement Tuesday, it will still stress that there is no urgency to raise interest rates.

"We believe they do want to continue to send a message that there's time to make a move back towards neutral policy," he said.

Such comments could surprise bond investors, who have sent yields up sharply over the past month as expectations for a rate hike this summer have increased sharply. The yield on the 10-year Treasury note was sitting close to an eight-month high Monday on speculation that the Fed would signal that an increase in rates is imminent. Fed funds futures contracts are fully pricing in an August rate increase but a number of analysts think the central bank could move as early as June.

Ashraf Laidi, chief currency strategist at MG Financial Group, believes the Fed should use Tuesday's meeting as a "stepping stone towards a 25 basis point hike in June."

If the Fed stands pat at the June meeting and the economic data continue to be strong, Fed officials could be seen as falling behind the curve on inflation, he said. "The next meeting won't be until August -- two payroll reports later. Should those reports show strong job creation, the Fed will then have to tighten by 50 bps

basis points in August, which may appear to be too late, always a negative for the markets and the dollar."

Still, McKelvey expects the economic data for April and May to be mixed, and others agree.

Despite the big reaction in financial markets of late, Sung Won Sohn, chief economist at Wells Fargo, said there's little evidence that the economy is entering a sustained period of strong growth. "The economy is doing well but we need more confirmation," he said. "We don't have a trend yet."