Market participants do not expect the Federal Open Market Committee to announce interest rate changes on Wednesday when it ends its two-day meeting here, but plan to closely analyze the FOMC's policy statement for hints as to which problem worries the Fed more: inflation or the weakening economy.
The FOMC consists of 12 voting members seven members of the Board of Governors of the Federal Reserve system, the president of the Federal Reserve Bank of New York, and four of the remaining 11 reserve bank presidents hold eight meetings per year to determine monetary policy.
Economists and the federal funds futures traders say the FOMC is almost certain to hold interest rates at two percent the Fed's first pause since it began cutting rates in September 2007. The Fed has slashed interest rates 325 basis points as the credit and subprime crises began to weaken the economy last summer. Since then, surging commodity prices have sparked inflation concerns and fueled debate both within the Fed and from market participants about whether the Fed should continue to hold rates steady.
Economists will be looking for clues in the wording and structure of the FOMC statement that indicate future Fed policy.
The Fed may tip its hand by the way it orders the economic concerns in the policy statement, said John Lonski, chief economist with Moody's Capital Markets Group. The Fed is likely more troubled by the weakening economy if that is mentioned ahead of inflation concerns, he said.
"It's an indirect way of showing how they prioritize," Lonski said.
The statement's third paragraph may hold key insight into the Fed's future rate decisions, said Robert V. DiClemente chief U.S. economist at Citi. The Fed's wording in its statement that its actions had mitigated downside risks, suggesting an end to rate cuts. Now that paragraph needs to be "reoriented," DiClemente said, as the Fed considers future interest rate tightening.
"The whole point of this week is [to] transition without indicating a move in August," DiClemente said.
Interest rate futures traded at the Chicago Board of Trade indicate an 8% chance that the Fed will raise rates on Wednesday. But the market expects the Fed will raise the federal funds rate by 25 basis points in October and then another 25 basis points by the end of the year.
Lonski, however, said interest rate futures are a poor indicator of upcoming Fed policy. He said he tells investors not to use the futures to predict interest rates.
Standard & Poor's chief economist David Wyss said he does not expect any changes in interest rates or significant changes in the language except a possibly stronger statement against inflation.
"I really don't think they will raise rates before the election," Wyss said. "[The Fed] is not political, but [it's] not stupid."
Wyss said he expects the economy to be at its worst by the beginning of 2009 as fuel costs and the housing slump continue to drag on the economy.
"Recessions occur when the economy is hit from two sides at once," he said as housing prices continue to drop and fuel prices remain high.
Lonski agrees. He pointed to the drop in stock prices since the last FOMC meeting and widening spreads in volatility and credit default swaps as evidence that the economy will weaken further before it improves.
But higher prices have triggered calls for higher interest rates from inflation hawks. At the last three FOMC meetings, at least one and sometimes two voting members dissented in favor of staying put. Those members Richard W. Fisher and Charles I. Plosser, the Fed governors from Dallas and Philadelphia respectively have said publicly they would like to see the Fed take a stronger stance against inflation.
"It would be beneficial if Bernanke used his power to obtain a unanimous vote on this decision," Lonski said. "Previously, there's been a lack of clarity from the Fed."
DiClemente said dissenters might want to "get along" to leverage more bargaining power in future meetings.
"I would be surprised if the guys on the edge would be dissenting [at this meeting]," he said.