World’s financial markets on edge ahead of Fed decision

The Federal Reserve will decide later today whether the US economy is finally resilient enough to withstand less policy support, or whether it is prudent to wait a bit longer.

With the world’s financial markets on edge, the US central bank wraps up a two-day meeting with a highly anticipated policy announcement at 2 pm (7pm Irish time), followed by Ben Bernanke’s last news conference as Fed chairman a half hour later.

Recent growth in jobs and retail sales, as well as a fresh budget deal in Congress, has convinced a growing number of economists the time is right for the Fed to trim its $85 billion in monthly bond purchases.

The 15-month-old program is meant to put downward pressure on long-term borrowing costs in order to stimulate investment and hiring. But many observers believe the central bank will wait until early in the new year, given persistently low inflation and the fact that the world’s largest economy has stumbled several times in its crawl out of the 2007-2009 recession.

"It is increasingly looking like a coin flip," said Michael Feroli, JPMorgan's chief US economist. If it waits, the Fed might still decide to better telegraph how it plans to wind down the stimulus program, as a handful of its 18 policymakers have suggested in recent weeks.

The Fed has kept interest rates near zero since 2008 and plans to leave them there for a while longer irrespective of when it begins to taper the bond buying. The purchases have swelled its balance sheet to a record $3.9 trillion.

The unprecedented money-printing has helped drive US stocks to record highs and sparked sharp gyrations in foreign currencies, including a drop in emerging markets this year as investors anticipated an end to the easing.

There has also been some anxiety in the United States that it could fuel inflation and hard-to-detect asset price bubbles. Fed officials will also update their economic forecasts today, likely acknowledging the faster-than-expected drop in joblessness to a five-year low of 7 per cent last month.

Perhaps most critically for investors, they could also tinker with their longer-term policy promises.

As it stands, officials have said the Fed will continue buying bonds until there is a substantial and sustainable pick-up in the labour market. They also want to see inflation rise somewhat from its current level of near 1 per cent.

Mr Bernanke will likely double down on his message that interest rates will stay near zero at least until unemployment falls to 6.5 per cent, as long as inflation does not threaten to top 2.5 per cent. The Fed could even lower that 6.5 per cent jobless rate threshold, or add a third marker that promises low rates if inflation remains below 1.5 per cent - moves that would be more likely if it decides to reduce its bond buying.

The fear is that a cut to the treasury and mortgage-bond purchases - even if only by around $10 billion per month - will lead to a market sell-off that will hike mortgage rates and other borrowing costs, choking the economy’s recovery.

Many borrowing costs, including for mortgages, are pegged to the yield on the 10-year US treasury note, which moves inversely to its price.

Accompanying any reduction with steps that offer reassurance that the Fed is not withdrawing its monetary support for the economy could help temper the market reaction.

The Fed policy meeting will be the penultimate one of Mr Bernanke’s tenure. His second four-year term as chairman of the central bank expires on January 31st, just two days after the close of the Fed’s first policy meeting of 2014.

Janet Yellen, the Fed's vice chairwoman and a strong proponent of the Fed's aggressive policy response to the recession, is positioned to succeed Mr Bernanke. The US Senate is expected to vote to confirm her for the post tomorrow.

Reuters