The Hindu Business Line : FOMC: Downbeat assessment and vow for low rates?

Since it last met, approximately six weeks ago, there is a pullback in the flow of bad news. But jobs are still being lost and industrial production is down. The most telling sign is the dramatic fall in the trade deficit, which has plunged to just about $25 billion compared with around $65 billion in earlier months and speaks of the magnitude of destruction of consumer spending in the import-intensive US economy.

There are some positives: housing seems to be bottoming, retail sales grew, leading indicators turned better — helped by the stock rally and steepening yield curve — and risk spreads in the inter-bank and corporate bond markets are shrinking.

The biggest relief for Fed Chairman Ben Bernanke and company must undoubtedly be the very restrained inflation. Headline indices are actually falling while the ‘core’ rate is well below the 2 per cent threshold favoured by the Fed. The unleashed liquidity and the soaring budget deficit have had pretty much no impact.

In fact, the worry is different. Bond yields are rising, jettisoning prospects. They affect not only new investments but also existing house prices and secondary market mortgage values and those of securitised debt and CDOs and, if persistent, might derail the Obama Administration’s much ballyhooed ‘legacy securities program’ in which private investors are being induced to buy off the illiquid paper in the portfolios of financial institutions, so that the latter can shrink their balance sheets and raise capital more easily.

At its current meeting, the Fed will, of course, not disturb its zero rate policy. But the growing gap between bond yields and short-term rates shows the market thinks the Fed will tighten sooner than later.

It has an opportunity to send a message through its widely-anticipated post-meeting statement. At its last but one meeting, bond prices surged when plans to buy Treasuries and mortgages to stop an unjustified rise in their yields were unveiled.

It faces a similar piquant situation now. Ten-year treasury yields jumped to 4 per cent levels on the back of the jobs (loss!) report.

To contain bond yields, the FOMC could well decide to throw cold water on the possibility of an early turnaround in the economy. That doesn’t contradict current data, which only suggest the pain is not worsening.

Reinforcing this could be a commitment to unchanged rates for some time to come.

That will inflict a high cost on market players betting against bonds and set the tone for the much-needed fall in yields.

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