What to expect from the Fed

Wall Street ponders the next step for monetary policy.

By Anthony Mirhaydari Aug 10, 2010 8:10AM

MirhaydariAll eyes will be on the Federal Reserve today as members of the Open Market Committee conclude their interest rate policy meeting.

 

While most Wall Street economists don't expect any radical steps to be taken, a consensus opinion is beginning to emerge: With job growth anemic, the Fed is likely to embark and a second, smaller round of quantitative easing, or QE. This would involve the Fed's reinvesting the proceeds from its existing QE-related purchases, which would keep the money supply from shrinking and ensure that long-term interest rates stay low.

The first stage, you'll remember, started back in March 2009 and resulted in the Fed's buying up $1.4 trillion worth of U.S. Treasury bonds and mortgage securities. This funneled extra cash into the capital markets and helped stabilize the economy.


These initial purchases ended five months ago. And as these bonds mature, the Fed receives a cash payment. If it does nothing, this effectively reduces the amount of money in the system. Less money effectively equals higher interest rates.

 

MZM

 

Since the original QE purchases ended in March, the vigor of the economic recovery has waned. The European debt crisis and equity market volatility have weighed on sentiment. So now there are doubts that allowing cash to be pulled out of the system is a good idea. This is already happening as the MZM measure of the money supply is contracting on an annual basis for the first time since 1995 -- which you can see in the chart above.

 

According to Credit Suisse economist Neal Soss, the most plausible of the options being considered would see the Fed reinvest the proceeds from its mortgage securities. This would amount to something between $100 billion and $180 billion per year. While this is a drop in the bucket compared with the Fed's total holdings of $2.3 trillion, it would do much to soothe the nerves of investors worried about the premature withdrawal of monetary stimulus.

 

But not everyone thinks this way. Deutsche Bank economists, for instance, believe the job market isn't weak enough to cause the Fed to alter its policy. The 71,000 private jobs that were added in July marked the seventh consecutive monthly gain -- which occurred alongside a 0.1% increase in the workweek and a 4-cent increase in averagely hourly wage. As a result, they are anticipating a "decent" 0.5% increase to private salaries and wages for July.

This improvement is consistent with the healthy year-over-year improvements to employee tax receipts being recorded. These were up 4.5% last quarter and are tracking at a 6%+ rate so far in August. Companies are also lifting capital spending in a big way, with growth averaging 20% in the first half of the year. This was the fastest pace since the beginning of 1995.

 

Historically, job creation has followed in the wake of capital spending as new employees are brought on to operate the new equipment.

 

As a result, the Deutsche Bank team expects the Fed to merely alter its policy statement language to acknowledge recent weakening without committing to "QE 2" just yet. In their words:

 

"The improvement in financial conditions since the June 22-23 FOMC meeting (stock prices are higher, the dollar is lower and various credit spreads are tighter) as well as the fact the recovery is still proceeding -- albeit slowly and unevenly -- will embolden the Fed to keep policy on its present course."

 

This, I believe, is the most likely outcome of today's meeting.

 

Disclosure: The author does not own or control a position in any  company mentioned.

 

Be sure to check out Anthony's new advisory service, the Edge, which is launching in September. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.

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