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Fed Talking Hikes Can’t Keep The Market Down

The Federal Reserve this week will remain impassive about the recent volatility in financial markets after their two-day policy meeting, and continue to signal a policy of continued, gradual, rate hikes economists said.

“Some people may wish the Fed to hint about it,but the central bank won’t say it’s having second thoughts. Not this time. They have to wait to see how things move,” said Nathaniel Karp, chief economist at BBVA Compass, in an interview.

The Dow Jones Industrial Average fell 7.6% in October, the largest one-month percentage decline since May 2010. The S&P 500 index was down 9.4% for the month.

“The Fed needs to be appear that they are the ones flying the plane. The markets can’t dictate what the Fed is going to do,” Karp said.

Richard Moody, chief economist at Regions Financial Corp. in Birmingham, agreed: “Our view is that the FOMC is not, a least not yet, uncomfortable with the tightening in financial conditions brought about by lower equity prices.”

After two days of talks, the Fed will release a policy statement at 2 p.m. Eastern. This is the last FOMC meeting without a formal press conference with Fed Chairman Jerome Powell.

Some analysts said Powell’s comment in early October that “we’re a long way from neutral” was a trigger for the market selloff.

Roberto Perli, a partner at Cornerstone Macro, and a former economist at the Fed, said the statement would not try to walk anything back.

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Peril said the Fed statement can’t rewrite Powell’s comments because they were true.

Overall, Fed watchers expect little new in the policy statement, expecting the central bank to repeat that economic activity “has been rising at a strong rate.”

“The Fed doesn’t have a lot of work that needs to be done to the statement to prep the markets for December. They can punt this one if they want to,” said Omair Sharif, an economist at Societe Generale in New York.

During the meeting, Fed officials are expect to discuss the appropriate size of its balance sheet. The Fed has been slowly shrinking the balance sheet, which now stands at $4.1 trillion from a high of $4.5 trillion.

The Fed has been letting up to $50 billion of its bond holdings roll off every month. Investors are looking for hints on when the central bank is going to stop.

Underlying this decision is whether the Fed wants to continue using the current “floor” operating system that uses interest on excess reserves as the upper bound. Before the crisis, the Fed used a “corridor” system of scarce reserves.

No concrete conclusions from the discussion are expected, said Lou Crandall, chief economist at Wrightson ICAP. A summary is expected in the minutes of this week’s meeting that will be released on Nov. 29.

The Fed is also expected to make the second adjustment to its interest-on-excess reserve tool for lifting interest rates, but this isn’t expected to happen until December, Crandall said.

In June, the Fed raised the IOER by only 20 basis points rather than 25 in June.

This was to keep the effective fed funds rate in the midpoint of its policy range. A combination of factors is pushing the effective funds rate towards the top of the range. Some analysts said this was another sign the Fed might have to stop shrinking its balance sheet because reserves are getting scarce.

But last month, Simon Potter, the head of the markets group at the New York Fed, said he didn’t think the upward pressure on the effective federal funds rate is a sign the balance sheet shrinking needs to stop.