US Fed Sees Improving Financial Market Conditions and Labor Markets

As expected, the FOMC kept the target for the Fed funds rate in the 0 to 0.25% range and reiterated that the low level of the policy rate would likely be warranted "for an extended period."  The Fed reiterated the view that U.S. economic activity "continued to pick-up" and added that "the deterioration in the labour market is abating". The statement still maintains that the economy's performance will remain "weak for a time," although financial markets conditions are now considered to be "supportive" to the economy. 

The assessment of the inflation outlook was unchanged, with stable expectations and excess capacity within the economy likely to result in inflation remaining "subdued for some time." 

Similar to recent statements, it was the non-traditional measures that garnered more attention. The statement reiterated that the Fed will slow the pace of purchase of agency debt and agency MBS, with these programs being completed by the end of the first quarter of 2010. The Fed said that the improvement in financial markets points to most of its special liquidity facilities being allowed to expire on February 1, 2010

In today's statement, the Fed gave a nod to the better news on the economy and remarked on the improvement in both the labour market and financial market conditions. Additionally, policymakers highlighted that the various liquidity and credit easing measures will be allowed to lapse on schedule, suggesting that they are confident that the financial system is healing, although they retain the right to make adjustments as they see fit.

Given the extraordinary amount of spare capacity, inflation worries are off the Fed's radar screen for now, providing the leeway to keep interest rates low until the recovery's momentum is strong enough to eat away at some of the excess supply.  The Fed is likely to maintain the low level of the funds rate until the whopping output gap is whittled away and seems committed to allowing the less traditional measures—put in place to support financial markets and the economy — to fade away. In our view, it is likely to take the next year before higher rates are deemed necessary by the Fed, and we retain our call that the funds rate will remain in the current range until late in 2010.