FOMC Overview from the firm

In contrast with the last FOMC meeting, the August meeting should provide a forward-looking statement that will signal the central bank's next step toward winding down its quantitative easing program.

Some salient points:

· U.S. monetary policy will remain on hold for an extended period.
· The Federal Reserve is not monetizing the federal debt.
· The commercial real estate sector is a growing concern.

The Fed will acknowledge improvement in the economy and the probability of stronger than expected growth in the third quarter, but carefully outline downside risks to both growth and inflation. The committee will maintain its commitment to keeping rates low for an extended period. Policy normalization will be difficult. Improving financial conditions and the pickup in real activity have stimulated demand for an early exit from financial markets. The timing, pace and sequence of policy normalization will have important implications for asset markets. The Fed is aware of the policy missteps it made in 1937, and those of the Japanese central bank in 1997 and 2000 that prematurely terminated economic recoveries.

Deflationary risk, potential problems in the commercial real estate sector and more stress in financial markets should cause policy normalization to proceed in a drawn-out fashion. Moreover, the risk that domestic political tensions will constrain future fiscal stimulus should ensure the central bank moves carefully before articulating an explicit exit strategy.
The FOMC acknowledged in its June minutes that it did not extend its asset purchase program out of fear this would be interpreted as a monetization of U.S. federal debt. The normalization of financial markets has given the central bank leeway to let some of its temporary liquidity programs expire. The Fed is likely to address its $300 billion asset purchase program which is about to expire. The Fed has purchased $243 billion in medium- to long-term Treasuries since the March 18 FOMC meeting. Although the program will end, one would expect the statement will provide enough space for the central bank to re-enter markets again should the financial sector experience more turmoil in the near term.
Some Risks - End the TARP but extend the TALF?

The FOMC will note the improvement but also emphasize risks to the spending outlook. While the improvement in productivity is desirable, firms obtained it by squeezing more out of a reduced workforce. Employee hours fell 7.6% in the second quarter. Outside of a modest increase in hours worked inside the July payroll data, the prospects for wage stabilization remain difficult.

Moreover, the increased prospects for growth in the current quarter come with a risk. The policy success of the auto subsidies is likely to shift consumption that would have occurred over the next several months to the current quarter. In addition, the inventory restocking contains its own risk. It is not yet certain that demand, due to the decline in wage income, is sufficient to absorb the increase in production observed in the current quarter.

Other risks include the shutdown of the $700 billion CMBS market since September 2008. In June, the central bank expanded its Term Asset-Backed Securities Loan Facility to include up to $100 billion in commercial mortgage-backed assets. While the asset purchase program will be allowed to expire, it is increasingly likely that the TALF program will have to be extended to address issues in the commercial mortgage-backed securities market.

Thus, the Fed will be reluctant to rule out additional liquidity measures to address possible turmoil in commercial real estate or additional stress in the banking industry. Commercial real estate prices fell 27% on an annualized basis through March 31 of this year. In contrast with the TED spread and Libor rates, options-adjusted CMBS spreads over Treasuries remain near levels seen at the peak of the crisis. Falling prices and an inability to roll over CMBS may require further unorthodox steps from the central bank.


posted by Peter Greene