Steve Blitz Morning Notes

The Fed has moved from agnostic to true believer when it comes to economic recovery. More specifically, they see a "V" shaped return to positive growth as a better bet than a slow upturn. They signaled their upgrade of the economy's prospects by stating that economic activity has "picked up" rather than "is leveling out" (August statement) and that the FOMC now believes their policies will "support a strengthening of economic growth" rather than "contribute to a gradual resumption of sustainable economic growth".

The Fed is going to test its belief first by reducing their support of the credit market. They signal that the financial crisis is over when they state that the Fed will now only "continue to employ all available tools" rather than "employ a wide range of tools". The narrower need for policy options is underscored by the FOMC pushing out the finish line of its plan to purchase $1.25 trillion in agency mortgage-backed securities from year-end to March 2010. Buying less per week means less market support and you can be sure that should conditions warrant they will end up owning less than the targeted amount. The proof-in-the-pudding will be how credit spreads react as the Fed begins tip-toeing away from the market.

Belief, however, is not certainty and the Fed made sure to let everyone know that it sees only a "gradual return to higher levels of resource utilization" -- meaning high unemployment and low factory usage is going to be with us for quite a while longer. Capacity utilization is the Fed's real time indicator of when the punch bowl needs to leave the party and utilization rates are still below the lows of the previous recessions (see earlier blogs). "V" shaped or not, it will take a long time before we see levels that made the Fed tighten in the past. Therefore the FOMC "expects that inflation will remain subdued for some time". To underscore the greater impact of resource utilization on overall inflationary pressures, the FOMC removed any reference to energy and commodity prices.

In other words first steps first -- remove the market's liquidity underpinnings before even considering a higher Federal funds rate. And if past is prologue we will be well into 2011 at best before the funds rate is above 0.25%.