Vital Signs: What Will the Fed Say Now?

The Fed will command center stage this week, as the markets await the central bank’s policy statement on Wednesday at 2:15 p.m. Fed-watchers are unanimous in expecting no change in the Fed’s 2% target rate, but Wall Street is somewhat anxious about how the statement will portray the policymakers’ balance of risks between recession and inflation. For months, the Fed has shown a clear bias toward actions that would support weak economic growth and fragile financial markets. That attitude appears to have changed.

Recent hawkish remarks by Chairman Ben Bernanke, downplaying the risks to growth while elevating concerns about future inflation, suggest a statement that will place these risks roughly in balance. A balanced assessment of risks would mean the Fed’s next move on rates could be either up or down, depending on how the economic data fall. The statement after the Apr. 30 meeting made a slight shift in this direction, but Fed-watchers expect a more definitive wording this time.

What has the markets on edge right now is the fear that the Fed’s assessment of risks could swing all the way toward making inflation its predominate policy concern. In that case, the policymakers would be signaling that its next move would more likely be a rate hike than a cut. However, that seems unlikely, especially given recent efforts of unnamed Fed officials, via communications with the Wall Street Journal and Financial Times, to tone down market expectations of future rate increases. Bond yields had jumped on Bernanke’s remarks, and the markets had fully priced-in three quarter-point hikes by yearend. Yields and rate expectations have since retreated somewhat.

The stubbornness of overall inflation and the Fed’s increased attention to it are also unnerving stock investors. Eventually, the Fed will have to begin lifting its target rate back to more normal levels consistent with its long-run inflation goal. The stock market’s growing worry is that the Fed may have to begin hiking rates, even in a relatively weak economic climate, in order to protect its credibility and assure that inflation expectations stay down. That’s hardly a growth scenario conducive to a rebound in earnings.

Data this week seem certain to validate that weak climate. On Wednesday, durable goods orders are expected to reflect the factory sector’s malaise and on Thursday look for a slight upward revision to the 0.9% pace of first-quarter GDP growth. The rest of the week’s reports will cluster around housing and consumers. Households are expected to have remained down in the dumps in June, when the two major confidence indexes are reported on Tuesday and Friday. But May’s personal income data should show a big aftertax impact from the rebates.

Sales of new homes, due on Wednesday, had ticked up in April for the first time in six months, but no follow-through in May is expected. Existing-home sales, to be reported on Thursday, have shown clear signs of stabilizing, but inventories remain near a record level, pushing prices down. Look for more bad news on prices on Tuesday from both the S&P Case-Shiller and OFHEO indexes. Talk of Fed rate hikes is already having one negative impact on the housing outlook: Mortgage rates have jumped from 6.1% to 6.4% in only the past two weeks.

Here’s the weekly economic calendar, from Action Economics.

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