The Federal Reserve is widely expected to announce another $10 billion monthly reduction in quantitative easing in Wednesday’s FOMC statement. But the focus will be on the Fed’s economic assessment, which could end up dramatically realigning investor expectations about when the Fed will hike rates.
In its previous statement, issued in late April, the Federal Open Market Committee noted that “growth in economic activity has picked up recently, after having slowed sharply during the winter,” but added that “labor market indicators were mixed” and “the unemployment rate… remains elevated.”
The economic outlook certainly seems to have improved since then. The last two employment reports showed monthly nonfarm payrolls growth of 282,000 and 217,000. And after a severely weak first quarter, several economists are looking forward to Q2 GDP growth around 4 percent.
Ironically, at 2.8 percent to 3.0 percent, the Fed’s current full-year GDP projections may be too high, simply because of the weather-related contraction in the first quarter. But they could still be understating the overall strength in the economy. And if the Fed acknowledges that the American economy may be entering into a period of above-trend growth, that could distort expectations about the future target of the federal funds rate, the highly influential rate at which banks lend to each other.
“The risk going into the meeting is for a slightly more hawkish tone than the market is expecting,” Societe Generale chief U.S. economist Aneta Markowska wrote to CNBC.com. “We see quite a bit of room for upgrades to the current economic assessment. … Labor market conditions are no longer ‘mixed,’ and continue to show further improvement.”
Given the current economic outlook, the market expectations for interest rates may be “unrealistically low,” and to the extent that this has “driven complacency and risk taking, I think the Fed may opt to lean gently against them,” Markowska wrote.
Other experts, like Newedge co-head of financial futures and options David Robin, expect the Fed to maintain the status quo as much as it can.
“I expect the Fed to deliver a statement next week virtually identical to the statement released in late April, perhaps tweeking, slightly, the growth forecast, but holding quite firm to the lower-for-longer policy view.”
But the issue is that an update of its color commentary on the economy could itself be sufficient to force investors to rethink the expected policy path.
“While the Fed is unlikely to alter its tapering plans or tweak its forward guidance, its new economic projections could still prompt speculation that the first interest rate hike may come earlier than mid-2015,” according to a recent note from macro research firm Capital Economics.
Troublingly, these new Fed jitters could crop up just as the market is running into geopolitical concerns surrounding the situation in Iraq and its impact on crude oil.
“The stock market needs the Fed to be a little more dovish right now,” said Scott Nations, chief investment officer at Chicago-based NationsShares. And partially because he is not expecting that outcome, Nations now advises shorting S&P 500 futures.
—By CNBC’s Alex Rosenberg.