Fed remains in stimulus mode but eyes exit strategy

The Federal Reserve concludes a two-day meeting Wednesday expected to reaffirm its massive economic stimulus but with an eye toward an exit strategy as recovery takes root.

The Federal Open Market Committee (FOMC) headed by Fed chairman Ben Bernanke began meeting at 1800 GMT and was to issue a statement Wednesday around 1815 GMT.

Analysts say the panel is virtually certain to maintain a near-zero base rate along with an array of programs to keep credit flowing, to support a fragile recovery from recession.

The tone of the statement however could provide hints on the speed and shape of the economic recovery, and any monetary policy response in the coming months.

Ethan Harris, economist at Bank of America-Merrill Lynch, said that while "it is too early to be thinking about a rate hike, we will be combing through the press statement for any details on an exit strategy and a recognition from the Fed that economic growth is beginning to pick up."

Harris said the Fed must keep watch on potential inflation pressures as a recovery gathers momentum because of the huge amount of liquidity it has pumped into the financial system.

But he said the Fed is facing a difficult task.

"Fed officials look back on history and recall two major mistakes: the failure to stop the Great Depression of the 1930s and the failure to stop the Great Inflation of the 1970s," he said.

Donald Ratajczak, economist at Georgia State University and consultant to Morgan Keegan, said he believes the federal funds rate "will remain near zero until employment grows and that will not happen until sometime in the winter at the earliest."

Bernanke said last week the US recession "is very likely over" but that the economy remains weak due to difficult credit conditions and high unemployment.

Jeremy Siegel, adviser to Nuveen Investments and finance professor at the University of Pennsylvania, said the Fed is unlikely to make any change in policy.

"I think the Fed's medicine is working and there is no reason to change the dosage," he said.

Siegel said the tone of the Fed statement will however send a strong signal.

"I expect the Fed will keep the same wording for the directive with respect to the Fed funds rate, specifically to maintain 'exceptionally low levels of the Federal funds rate for an extended period,'" said Siegel.

"I think any changes to those words would be an extraordinary event and cause a large negative reaction in the equity markets."

Siegel said the Fed may be somewhat concerned about the low level of the dollar and surge in prices of gold and other commodities. Both could be addressed with a hike in rates, but that is not likely soon, he said.

"I expect the Fed to keep this accommodative stance unless commodities in general, and oil specifically, rise much further or the dollar takes a sharp move downward," he said.

John Ryding, chief economist at RDQ Economics, said the Fed cannot even think about hiking rates with the current degree of economic slack and joblessness.

"With so much slack in the economy, the Fed is not going to be inclined to raise rates anytime soon," Ryding said.

With the federal funds rate seemingly frozen at zero to 0.25 percent, the central bank's only policy option revolves around its various liquidity programs implemented since last year's credit freeze.

The Fed last month indicated it would conclude its 300-billion-dollar program to purchase Treasury bonds, part of a program to bring down interest rates which some call "quantitative easing."

It must decide however on whether to extend into 2010 a trillion-dollar program to purchase mortgage securities, which is aimed at keeping credit flowing to the still-weak housing market.

US gross domestic product (GDP), the broadest measure of the economy's activity, fell at an annualized rate of 1.0 percent in the second quarter, after a 6.4 percent plunge in the January-March period.

But unemployment rose in August to a 26-year high of 9.7 percent amid a growing fear joblessness may hit 10 percent before a full recovery takes root.