By Steven K. Beckner

On the other hand, Bullard said Monday in Tokyo that the European
crisis has not affected the timing of Fed rate hikes, which he suggested
are still some way off.

Bullard went so far as to say that the United States may be a net
“beneficiary” of the European situation, because “the crisis has
produced at least two advantages for the U.S. in the near term.”

Not only has the European crisis pushed up the value of the dollar
and reduced the cost of energy and other commodities, he said, it has
slashed 10-year Treasury note yields from 4.0% to less than 3.2%.

“To the extent this type of movement is sustained, it affects all
trading in U.S. financial markets and acts like an aggressive and
successful monetary policy action,” Bullard observed. “If the situation
in Europe continues to spark market volatility, the flight to quality
will sustain lower yields in the U.S. than would otherwise be the

In addition to setting the federal funds rate target and deciding
on the appropriate language of the policy statement, the FOMC will be
revising its quarterly three-year and “longer run” forecasts of growth,
employment and inflation. At its April meeting, Fed presidents and
governors upgraded their forecast, but only slightly, and they warned of
greater than usual uncertainty.

There is little reason to expect much, if any, additional upward
revision to growth and job forecasts. Indeed, some officials may well
downgrade their outlook due to the European crisis.

The Fed’s latest “beige book” survey, prepared for the upcoming
meeting, was positive, but not wildly so.

The 12 Federal Reserve Banks’ survey of business and banking
contacts in their districts found that the economy continued to improve
through late May. But growth was described as just “modest” in many of
the districts. There were increases in consumer spending, but spending
was “concentrated on necessities as opposed to discretionary big-ticket
items.” Business spending was up “moderately.”

Labor market conditions “improved slightly.” Permanent hiring
“edged up” in most districts, and there was a rise in hiring of
“temporary” workers in many places.

With unemployment still high, the Fed found “limited” wage
pressures. And prices of goods and services “were largely unchanged” in
most districts. Though raw material costs had risen, they were “not
being passed along to customers.”

One thing that has improved notably of late is stock prices, but
this followed a wealth-destroying correction that has yet to be
completely reversed.

In any case, it would appear that there’s a long way to go before
the FOMC consensus becomes sufficiently more comfortable about those
“headwinds” to begin making policy less accommodative.

To be sure, the Fed is continuing to hone its “exit strategy”
tools, having recently begun testing of its term deposit facility, one
means of absorbing excess reserves. But, as the Fed said in announcing
them, “these auctions are a matter of prudent planning and have no
implications for the near-term conduct of monetary policy.”

Ultimately, reserve draining on a larger scale will probably
proceed increases in the funds rate target and in the interest paid on
excess reserves (IOER), but only after the FOMC drops or modifies the
“extended period” language and only after draining operations are
clearly announced and scheduled well in advance.

At this stage, it looks increasingly likely that the soonest the
first step — changing the language — will come is late this year,
pushing actual tightening into next year. That’s all contingent, as the
FOMC has said, on what happens with “economic conditions, including low
rates of resource utilization, subdued inflation trends, and stable
inflation expectations.”

The outlook for those variables remains highly uncertain, for all
of the reasons discussed above plus the prospect of higher taxes and oil
prices, not to mention the devastating regional impact of the Gulf oil

Until Bernanke and the Fed majority become convinced that private,
rather than government, jobs are being created and credit extended at a
sufficient pace to sustain recovery, they seem unwilling to make policy
less accommodative.

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** Market News International **

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