As usual, the
needs to watch its step in wording the policy statement it will release after Tuesday's Federal Open Market Committee meeting. Last time it opened its mouth, the central bank sparked a rout in the bond market that is only beginning to wane.
Alan Greenspan's latest tightrope is this: He must praise the economy enough to please his beloved stock market while at the same time not seeming so optimistic that bonds resume their tumble.
Experts say Fed policymakers are painfully aware of the problem after Greenspan's semiannual speech before Congress, when he noted the central bank would not take any special actions in order to ward off deflation. The result was a more-than-1-percentage-point spike in Treasury yields.
"We'd like to see the Fed somewhere between sounding optimistic and cautious," said Tony Crescenzi, chief bond strategist at Miller Tabak & Co. and contributor to
. "The idea is the Fed's own words have caused a lot of volatility in the markets, sparking the whole anomalous deflation episode, with rates plunging and subsequently moving up dramatically when it looked like the Fed was no longer worried about deflation."
So how can the Fed pull it off? By emphasizing that the U.S. economy has begun to expand, but not at a fast-enough pace that would lead it to raise interest rates any time soon. That, and acknowledgement that inflation is still very low and the amount of slack in the economy remains high.
"If they are very detailed and make it very clear that they will be highly accommodative for a long period, bonds will react positively," said Jim O'Sullivan, U.S. economist at UBS Warburg.
A crucial point in striking the delicate balance the Fed seeks will be maintaining a degree of uncertainty regarding inflation, analysts say. While most agree the probability of its disinflation is currently low, a signal from the Fed that lower prices are not a concern would be more than the bond market could withstand, causing a further increase in rates.
"If they remove or alter in any way the previous statement that the risk of a decline in inflation is greater than that of an increase, it would suggest an unequivocal belief that the need to cut rates has diminished and the next move might be up," Crescenzi said.
Mike Cloherty, market strategist at CSFB, also believes the Fed will reiterate that there is still some risk of disinflation. "By reiterating that bias, the Fed signals it won't tighten for a long time."
One way or the other, the Fed won't be able to avoid recognizing the economy has indeed shown indications it is gaining momentum. "It will clearly have to acknowledge growth numbers are better," said O'Sullivan.
Analysts point at the recent business surveys as a sign the recovery is accelerating, including the manufacturing index at the Institute for Supply Management, which has risen for the past three months. Government reports this week also could show U.S. retail sales rose at a faster clip in July, industrial production grew for a third-consecutive month and that first-time jobless claims are stuck below the critical 400,000 mark for a fourth week in a row.
Despite this acceleration, most economists expect the Fed to keep rates unchanged at 1% in Tuesday's meeting, their lowest in 45 years. But views shift in the longer term. Fed funds futures are currently pricing in 40% odds of a rate hike in January, and 60% in March.
Growth expectations sent the yield on the 10-year note to a high of 4.59% last week, reinforcing concerns that rising rates would hinder the faltering economic recovery.
"Policymakers don't want the bond market to keep selling off," said O'Sullivan, at UBS, who noted that with current interest rates, growth would be less buoyant, with the continued rise in a few of the economy's pillars, such as the housing market, being thwarted.
Others say Fed officials will try to avoid any statements that would persuade investors one way or the other about the economy. Crescenzi said "they will want to remove themselves from the business of micromanaging market expectations on interest rates, so the statement will be tailored to be as neutral as possible to let any movement in rates be a result of factors other than the Fed."