FOMC Votes to Keep Rates Steady—U.S. Equity Markets Charge Higher

The FOMC stated that labor markets were weak and financial markets remained under considerable stress—the growth outlook has deteriorated since the June 25 meeting. Inflation has been high and the outlook appears highly uncertain; the upside risks to inflation are a "significant" concern.

The Fed's decision to hold interest rates steady was widely anticipated by the markets, although some did expect a rate hike. The market reaction was generally positive—equity prices had already moved up in anticipation of the decision, and market charged higher after the press statement was released.

With respect to the economic outlook, the Federal Open Market Committee's press statement removed the June 25 reference that "downside risks to growth have diminished somewhat." Instead, the committee reiterated that tight credit conditions, the ongoing housing contraction, and the rise in energy prices are likely to weigh on economic growth over the next few quarters. We read this as a gloomier FOMC assessment of downside risks to growth since the June meeting.

With respect to inflation, the Fed continues to expect inflation to moderate, but the outlook is uncertain. Upside risks to inflation remain a "significant" concern, but the FOMC did not say that these risks had increased since its previous meeting. This characterization was designed to placate some regional Fed presidents who have carved out hawkish positions on the inflation outlook.

The Fed has been increasingly hemmed in by upside risks to inflation versus downside risks to growth. The good news at this juncture is that world economic growth has downshifted enough to induce a large downward correction in commodity prices—the positive benefits of which will become evident in September's data releases. That should provide the FOMC with a little more breathing room on policy as autumn approaches—a period fraught with further uncertainty as the effects of the economic stimulus rebates wear off.

Under these circumstances, we believe that the Fed will be in a position to hold interest rates steady well into next year—longer than what the markets currently expect. The timing of the recent break in commodity prices, therefore, could well prove to be providential for the U.S. economic outlook, particularly in the second half of 2009.