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Steady on Policy Rate, but Alert to Inflationary Pressures

The Federal Open Market Committee (FOMC) left its target for the federal funds rate unchanged at 2 percent on June 25. This outcome surprised few: The market's assessment of the probability of a rate change never rose above 25 percent during the intermeeting period.

June Meeting Outcomes

Immediately after the April 30 meeting, market participants expected the FOMC to hold the policy rate steady at least through the summer. However, when incoming data failed to confirm that the economy was in a recession, a rate hike of at least 25 basis points in August emerged as the most likely prospect. But by mid-June, the no-change outcome reemerged as the most likely one.

August Meeting Outcomes

Prices for Federal funds futures revealed a similar story. The highest and steepest trajectory for implied yields occurred in the second week of June, when stronger-than-expected data on the economy were released and some Fed officials expressed concerns about inflationary pressures.

Implied Yields on Federal Funds Futures

In its post-meeting statement, the FOMC noted that "[t]ight credit conditions, the ongoing credit contraction, and the rise in energy prices are likely to weigh on economic growth over the next few quarters." Moreover, "the Committee expects inflation to moderate later this year and next year."

The FOMC's assessment of risks indicated that the "substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time. Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased."

The market's reaction to the June 25 policy announcement has been limited. Initially, equity prices reacted favorably, adding more than half a percentage point to an ongoing rally of almost one percentage point. However, prices then declined somewhat, ending the day up about 60 basis points over the previous day's close. The bond market showed little reaction to the news. Although the market continues to expect an upward trajectory to the policy rate, the FOMC statement led participants to expect rate hikes to come later than sooner.

The rise in Reserve Bank credit during the intermeeting period was primarily a reflection of the higher amounts auctioned through the Term Auction Facility (TAF), a key new measure to foster market liquidity. Primary credit peaked in late May, driven largely by a rise in the number of institutions borrowing on net. Primary dealers have substantially reduced their reliance on the Primary Dealer Credit Facility.

Reserve Bank Credit

Although credit terms have tightened for some businesses and households, concerns about liquidity have lessened substantially. The spread between the term borrowing rate in the London interbank market (LIBOR) and the cash market rate (OIS) is a closely watched indicator of liquidity conditions. Spreads for both one-month and three-month borrowing have declined considerably from recent peaks, although they remain above their pre-crisis levels.

3-Month LIBOR Spread

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