With the Federal Funds target rate effectively at zero the typical rate cut is not an option this time, so what will the Fed’s uncertainty lead it to do?
1. First, the Fed will likely signal its sensitivity to heightened risk by updating the message from the June meeting that it “will employ its policy tools as necessary” to reflect the latest language from the recent semiannual testimony that it “is prepared to take further actions as needed.” This will send the signal that the Fed has a greater bias toward easing monetary policy. This signal alone may have some of the effects desired by the Fed on the markets.
2. Second, in lieu of the Fed cutting rates, they may reinvest interest and principal payments on the Fed’s holdings of Mortgage-Backed Securities back into the market with the intention of adding money to the system and keeping rates low. However, we believe the Fed is not likely to take this step without a downgrade to its recently stated growth outlook for above-average Gross Domestic Product (GDP) growth in 2011 and a 1% decline in the unemployment rate over the next year. The Fed has the ability to wait on any additional stimulus given the improvement in market conditions, from the stock market to the TED spread, since the last Fed meeting in June. If the uncertainty lingers, and the Fed further downgrades their outlook, the Fed could pursue the path of further easing consistent with prior early cycle periods of uncertainty.