PREVIEW-As risks mount, Fed to stick to zero rates policy

WHAT: Federal Reserve holds monetary policy meeting

WHEN: June 22-23; decision June 23, around 2:15 p.m.

REUTERS FORECAST: Primary dealers see no change in rates,
and believe the Fed will reiterate its commitment to keeping
interest rates “exceptionally low” for an “extended period.”

FACTORS TO WATCH:

With the Fed set to stay the course on rates, investors
will try to read the tea leaves by digging through any minor
changes to the language of the post-meeting statement outlining
the U.S. central bank’s views on the economy and policy.

Here are things to look for:

* Extended Period: The language stays in all likelihood.
Thomas Hoenig of the Kansas City Fed has dissented at the last
three meetings over the issue, believing the open-ended
commitment to low rates might create bubbles and other
financial imbalances. But with financial markets looking
rickety again, that argument becomes more difficult to make.
With no change expected here, markets will parse especially
closely the Fed’s assessment of economic conditions.

* Employment: The job outlook remains quite grim, something
Fed officials have repeatedly flagged as a key concern. The
economy has added new jobs for six of the last seven months,
but May’s private employment gains proved disappointing, with
most of the rise in payrolls coming from temporary U.S. census
hires. The jobless rate, at 9.7 percent, is still very high by
historical standards. Moreover, weekly initial jobless claims
have not budged much. Last week, they rose to 472,000.
[ID:nN17254724] That means the Fed could refrain from upgrading
its characterization of the labor market as “beginning to
improve.”

* Inflation: The near-term outlook for U.S. inflation is
very tame. All key indicators have been showing soft price
pressures. In fact, some have started to indicate a potentially
worrisome return to that perilous gray area between
disinflation and outright deflation. The Labor Department’s
consumer price index excluding food and energy rose just 0.9
percent year-on-year through May. The Cleveland Fed’s median
CPI, another core inflation measure that excludes outliers, has
been flat for five straight months and is up just 0.5 percent
in the year to May. Many Fed officials say they are not
concerned about deflation at the moment, but a renewed credit
crunch and a concomitant hit to the economy’s expansion could
alter that picture. Some, however, have worried that the Fed’s
bloated balance sheet could spark inflation down the road. This
key sentence probably stays intact: “With substantial resource
slack continuing to restrain cost pressures and longer-term
inflation expectations stable, inflation is likely to be
subdued for some time.”

* Financial Markets: The Fed could give a nod to recent
disruptions in financial markets, which have pushed the cost of
interbank borrowing near its highest levels in a year. In
April, the central bank said that “while bank lending continues
to contract, financial market conditions remain supportive of
economic growth.” With European banks having run into some
trouble, Fed officials may temper that view.

* Asset Sales: Before the Fed’s April meeting, there was
much speculation about whether the central bank might soon
embark on a program to sell some of the assets it acquired
battling the financial crisis as the first step to tighter
financial conditions. The minutes of that meeting did reveal
some detailed discussion of the matter. But various
pronouncements from key officials at the Fed’s board have made
it appear unlikely that such a plan would be implemented any
time soon.

* Discount Rate: Three regional Fed bank boards ahead of
the last policy gathering had called for the central bank to
further raise the rate it charges for emergency loans at the
discount window. The Fed had increased the discount rate by a
quarter point to 0.75 percent in February. However, any such
move is unlikely for now since there is internal disagreement
within the central bank about whether it makes sense to bring
the spread between it and the benchmark federal funds rate back
to the 100 basis points seen before the crisis.
[ID:nN08215948]

MARKET IMPACT: Investors are much more focused on
developments in Europe at the moment, making it unlikely that
financial markets will see major ripples following the Fed’s
decision. However, a bearish economic assessment from the
central bank, or any sign that the Fed is overtly worried about
inflation getting too low, could put some pressure on stocks,
serving as a reminder that the economic recovery is still
vulnerable. Falling equities, in turn, could give the dollar
and Treasury bond prices a boost.

Recent rate decisions (FEDFUNDU: )

Latest Fed poll [FED/R]

Fed balance sheet graphic http://link.reuters.com/buf92k

All U.S. economic data: (ECONALLUS: )

U.S. stocks (Read more about the stock market today. ) and Treasury bonds reports [.N] [US/]

Fed’s website www.federalreserve.gov

Investment Analysis

PREVIEW-As risks mount, Fed to stick to zero rates policy