by: Tim Duy

With the FOMC widely expected to hold the pace of its asset purchase program steady, the real action will be in the statement. Two issues bear watching, the economic outlook and and the forward guidance. The risk is that one or both are more dovish than the last FOMC statement. But, interestingly, being more dovish does not necessarily imply a delay to asset purchase tapering; it could also mean that the Fed leaves a September tapering in place, while using forward guidance to ease policy policy by signaling an even more extended period of low rates.

At this risk of oversimplifying the last FOMC statement, narrow the Fed's June outlook to:

Information received since the Federal Open Market Committee met in May suggests that economic activity has been expanding at a moderate pace...

... The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall.

Putting inflation aside for a moment, the Fed can move in a dovish direction by downgrading from "moderate" to "modest." As Calculated Risk notes, much here hinges on the Fed's interpretation of what is largely expected to be a weak GDP report (released the same day as the FOMC statement), on the order of 1% or less for the second quarter. I tend to think the Fed will largely dismiss the report as an artifact of fiscal contraction and other one-off events. Indeed, in his recent Congressional testimony, Federal Reserve Chairman Ben Bernanke indicated that the Fed's forecast had not changed significantly since the last FOMC meeting despite knowing that the second quarter GDP would be lackluster. Has he had a change of heart since then?

Another possible hint on the outlook could be the consistency of the last two Beige Books. From the June Beige Book:

Overall economic activity increased at a modest to moderate pace since the previous report across all Federal Reserve Districts except the Dallas District, which reported strong economic growth.

The language was similar in July:

Reports from the twelve Federal Reserve Districts indicate that overall economic activity continued to increase at a modest to moderate pace since the previous survey.

Arguably a downgrade, but I doubt policy is likely to shift on a minor pullback in activity in just one Federal Reserve District. Still, given that the data flow has certainly not been better than expected, even if they do not downgrade the basic assessment, they could suggest that the risks to the outlook are more balanced (rather than "diminished" as in June). With this in mind, recall that Bernanke's assessment of the risk appeared more balanced in his Congressional testimony, which suggests this week's FOMC statement will indicate the same.

Regarding inflation, the Fed last concluded:

The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective.

This assessment is not likely to change. Possible, though I think unlikely, would be a change to this sentence:

Partly reflecting transitory influences, inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable.

A decidedly dovish shift would be to remove the reference to "transitory influences." Even more dovish would be to suggest that inflation expectations are trending down, but I very much doubt the Fed will go that far.

In addition to shifting their assessment of the economy, the Fed may choose to tighten up it's forward guidance. Considering that Fed speakers, including Bernanke, have indicated that, given the inflation outlook, interest rates will remain unchanged even after the unemployment rate hits 6.5%, it seems possible that the FOMC could shift the unemployment threshold down to 6%. They could also formalize Bernanke's 7% unemployment for ending quantitative easing. What they won't do is increase the 2.5% inflation threshold; indeed, that one I view more as a trigger than a threshold in any event.

It may be the case that, barring a sharp deterioration in the economy, we will find that changes in the economic assessment should be interpreted as changes in the expected timing of the first rate hike rather than the pace of the exit from quantitative easing. This may be the case even if the forward guidance is left unchanged. The Fed seems to desire a shift in the mix of policy while maintaining the current level of accommodation, and they may use the statement to signal such an intention.

Moreover, arguably there is little harm at this point to sticking with a plan to end asset purchases by the middle of next year. Bernanke already shifted expectations in such a way that interest rates jumped to a new range around 2.5%. In order to reverse that increase, I suspect the Fed would need to do more than just suggest a delay in the tapering. I suspect they would need to surprise markets with an increase in the pace of purchases. But I don't see much appetite at the FOMC for such a move other than perhaps St. Louis Federal Reserve President James Bullard. Thus, FOMC members could decide that they still want out of QE and just use forward guidance to control the pace of any further rate gains.

Bottom Line: This will be a very interesting FOMC meeting even if the statement is left largely unchanged. That alone reveals that the Fed is moving ahead with their plan to taper undeterred by any soft spots in the data. After all, wouldn't this just be another midyear slowdown in the data flow? A move to a more dovish statement, either in the economic assessment or fine-tuning the forward guidance, however, does not necessarily mean any change in the plan to end asset purchases. It could all be about the timing of the first rate hike at this point. The plan to end asset purchases may have had more to do with market functioning than economic activity in the first place. And that debate is really over regardless of when the Fed actually tapers. Whether September or December or early next year is probably no longer very important; the date of the first rate hike, however, is still very important.