What will/should the Federal Reserve Do Next?

The Federal Reserve currently finds itself in a difficult balancing act.  On the one hand, it is trying to be an active participant in thawing the frozen credit markets and stimulating a U.S. economy that has been in recession since December of 2007 (according to the National Bureau of Economic Research – “NBER”). On the other hand, it recognizes the growing threat of inflation and the damage that inflation could have on an economy that is likely to start finding its legs again later in the year. In recognizing this threat, it realizes that some its own actions with respect to quantitative easing have added to mounting inflation concerns and many, including members of my research team here at Hennion & Walsh, are interested in the details of the Fed’s exit strategy in this regard.

Outtakes from the Federal Reserve’s Open Market Committee last week in addition to recent comments from Eric Rosengren, President & Chief Executive Officer of Federal Reserve Bank of Boston provide some insight into just how difficult it will be for the Fed to determine an ideal path – if one even exists. At the Open Market Committee meeting, the Fed terminated one money market liquidity program while extending many other existing liquidity programs.  This seems to suggest to me that the likelihood of an increase in interest rates anytime in the near future is low given that the Fed is signaling that they see more rough waters ahead.    Rosengren, during a speech at The Global Risk Regulation Summit in Brussels on June 29, 2009, struck a slightly more optimistic note saying, “GDP is expected to start being positive in the second half of this year�the unemployment rate is likely to lag, so the peak in the unemployment rate is likely to be sometime early next year.” This second statement would seem to contradict the first, as 70% of GDP is based on consumer spending, and one would think that as more Americans become unemployed, consumer spending will be lower.   This would lead one to question where will economic growth come from or, perhaps, will real growth likely not start to occur until the first two quarters of 2010?

The Federal Reserve will continue to struggle to find an exit strategy for the $1 trillion that it has already pumped into the system.   The timing of the exit strategy is critical and will likely be influenced by the timing of the return of economic growth (i.e. GDP). I would suggest that the inflationary consequences associated with not implementing a measured monetary tightening policy program soon will only intensify as each week passes.


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