What Investors Should Look For In Today’s FOMC Statement

In its continuing efforts to nurture the fragile economic recovery, the U.S. Federal Reserve is widely expected to leave interest rates at record lows when it concludes its meeting today (Wednesday).

However, observers will be closely examining the details of the language in the statement of the Federal Open Market Committee (FOMC) meeting for hints as to when it plans to change monetary policy.

The overwhelming consensus is that the Fed will hold the federal funds rate steady at near-zero until the second half of next year. But that assumes the economic growth will stay in line with the Fed’s current forecast - a weak recovery with subdued inflation and slow growth.

The real internal debate between Fed Chairman Ben Bernanke and his colleagues is likely to focus on how to signal a change in stance to investors, businesses and everyday Americans when it anticipates raising rates.

Change to Two Phrases Will Signal Policy Reversal

The key language most analysts will focus on is the Fed’s promise to keep rates “exceptionally low” for “an extended period.” Bernanke has been using those two phrases since March, and an Oct. 23 report in the Financial Times set off a firestorm when it suggested that the Fed was considering scrapping them.  Any changes to those words in the FOMC statement could blow up the bond markets, according to some analysts.

“Suggestions that the Fed might fiddle with the ‘extended period’ text of its statement are worrying,” analysts at ING Groep NV (ING) told the FT. “This phrase is dynamite - and should be handled only with extreme caution, better not at all in our opinion.”

Other analysts say the central bankers know the dangers involved and will avoid any changes for now.

“We don’t expect them to move away from the extended-period language,” Dean Maki, chief U.S. economist at Barclays Capital Inc. (BCS), in New York told MarketWatch.com.

But whatever they decide, most analysts feel the debate is likely to stay internal for now and say it’s highly unlikely the Fed will make any fundamental changes.

“I think they will stick with interest rates in the zero to quarter-point range and will mention that economic conditions are better, but still justify rates at low levels for an extended period,” David Jones of DMJ Advisors said.

Factors in the Fed’s Decision

Price pressures and unemployment will be the two key factors in the Fed’s policy decisions.

As of September, inflation was subdued, while the unemployment rate surged to a 16-year high of 9.8% - suggesting any move toward a reversal in policy would be premature.

“The facts on the ground - high unemployment, low inflation, no net private-sector job creation - suggest to us that it is inconceivable that policy will actually change on Nov. 4,” Credit Suisse Group AG (CS) said in a report to clients.

Consumer prices rose just 0.2% in September, an indication that inflationary pressures remain mild. And even though energy prices have increased since the last meeting - and are likely seen by some Fed governors as a risk - core inflation is trending down, having slipped 1.5% in the past 12 months.

Meanwhile, three years of declining home values, stagnant wages, and the unfavorable labor market has dampened consumers’ appetite to spend.

U.S. consumers curtailed spending in September for the first time in five months. And that decline in consumer spending - which accounts for almost 70% of all U.S. economic activity - is increasing fears that consumers will pull back this winter as the government’s spending programs run out of funding.

And with a “jobless recovery” on the horizon, the labor market could be too weak to support domestic demand, leading to concerns the economy’s nascent recovery could stumble once the government support wanes.

That’s why Federal Reserve Bank of St. Louis President James Bullard said in an interview with Bloomberg Radio that job growth was a top priority.

“You want some jobs growth and unemployment coming down,” Bullard said. “That is a prerequisite” for an increase in interest rates.

Some analysts expect it to peak at 10.5% next summer.

Coping with a Collapse in Commercial Real Estate

The labor market has stolen the spotlight in recent months, but there is still a large amount of uncertainty in the banking sector, which continues to suffer from tight credit, a spate of foreclosures and potential losses in commercial real estate (CRE).

Commercial property values in the U.S. have plummeted 36% since peaking in 2007, and the commercial real estate market is unlikely to recover before 2012, according to the quarterly PricewaterhouseCoopers Korpacz Real Estate Investor Survey, released in September.

Federal Reserve Associate Director of Banking Supervision and Regulation Jon Greenlee said in testimony before Congress this week that those large regional and community banking firms building up “unprecedented concentrations of CRE loans” will be particularly affected by emerging conditions in real estate markets.

Roughly $530 billion in mortgage-backed securities are due for refinancing between now and 2011, according to property researcher Foresight Analytics LLC, which estimates that the U.S. banking sector could incur as much as $250 billion in commercial real estate losses - enough to cause a as many as 700 banks to fail, in that time.

The Federal Deposit Insurance Corporation’s (FDIC) “problem list,” or banks that run a higher risk of failure, grew to 416 in the second quarter, up from 305 in the first quarter. That’s the highest number since the second quarter of 1994, when there were 434 banks on the list.

Greenlee says that prices for commercial properties would probably fall further and that many institutions would benefit from portfolio level stress testing, improved management information systems, and more robust appraisal practices, Reuters reported.

Another dark cloud appeared on the CRE market last week when the Fed threw out five commercial market bonds that were pledged as collateral for taxpayer loans to purchase debt.

In an effort to clean up bank balance sheets and encourage new lending, the Fed opened its Term Asset-Backed Securities Loan Facility (TALF) to so-called legacy commercial-mortgage bonds. TALF attracts buyers by pumping up returns with low-cost Fed loans. Bonds deemed too risky are rejected.

The rejections came as a surprise, and may limit future demand under the program.

“The Fed/collateral monitor is more concerned with credit risk than many expected,” Barclays analysts led by Aaron Bryson in New York, wrote in a note obtained by Bloomberg News.

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