The main observation we take away from the FOMC Minutes: UNCERTAINTY OVER THE IMPACT OF RISING ENERGY PRICES

Here is a brief recap of the internal debate surrounding the impact of expensive energy prices, using excerpts from the release....

In discussing intermeeting developments and their implications for the economic outlook, participants agreed that the information received since their previous meeting was broadly consistent with continuation of a moderate economic recovery, despite an unexpected slowing in the pace of economic growth in the first quarter.

Participants viewed the weakness in first-quarter economic growth as likely to be largely transitory, influenced by unusually severe weather, increases in energy and other commodity prices, and lower-than-expected defense spending. As a result, they saw economic growth picking up later this year.

Several participants indicated that, in contrast to the somewhat weaker recent economic data, their business contacts were more positive about the economy's prospects, which supported the participants' view that the recent weakness was likely to prove temporary. They acknowledged, however, that sentiment can change quickly; indeed, one participant noted that his contacts had recently turned more pessimistic, and several participants indicated that their business contacts expressed concern about the effects of higher commodity prices on their own costs and on the purchasing power of households

Growth in consumer spending remained moderate despite the effects of higher gasoline and food prices, which appeared to have largely offset the increase in disposable income from the payroll tax cut. Participants noted that these higher prices had weighed on consumer sentiment about near-term economic conditions but that underlying fundamentals for continued moderate growth in spending remained in place. These underlying factors included continued improvement in household balance sheets, easing credit conditions, and strengthening labor markets.

Although most participants continued to see the risks to their outlooks for economic growth as being broadly balanced, a number now judged those risks to be tilted to the downside. These downside risks included a larger-than-expected drag on household and business spending from higher energy prices, continued fiscal strains in Europe, larger-than-anticipated effects from supply disruptions in the aftermath of the disaster in Japan, continuing fiscal adjustments at all levels of government in the United States, financial disruptions that would be associated with a failure to increase the federal debt limit, and the possibility that the economic weakness in the first quarter was signaling less underlying momentum going forward.

However, participants also noted that the rapid decline in the unemployment rate over the past several months suggested the possibility of stronger-than-anticipated economic growth over coming quarters. Participants discussed whether the significant drop in the unemployment rate might be overstating the degree of improvement in labor markets because many of the unemployed have dropped out of the labor force or have accepted jobs that are less desirable than their former jobs.

A few participants noted that firms may be poised to accelerate their pace of hiring because they have exhausted potential productivity gains, but others indicated that some firms may be putting hiring plans on hold until they are more certain of the future trend in materials and other input costs.

Signs of rising wage pressures were reportedly limited to a few skilled job categories for which workers are in short supply, while, in general, increases in wages have been subdued.

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This is the debate we've been expecting to occur inside the FOMC Board Room......

January 12, 2011: Beige Book: Housing is Weakest Link. Wage Growth Missing. Margin Squeeze Looms

February 1, 2011: Margin Squeeze Concerns Deepen as Manufacturing Sector Expands

February 3, 2011: Productivity Gains Darken Hiring Outlook. How Might that Impact Housing?

February 16, 2011: FOMC Minutes: Harping on High Productivity & Margin Pressures

March 3, 2011: Inflation Expectations Distorted by Bullish Perspectives of Reality

March 17, 2011: Inflation Update: Cost of Living Rising as Wage Growth Lags

April 29, 2011: Economic Slowdown: Transitory Effects vs. False Starts

May 12, 2011: Margin Squeeze Hits Headlines. False Start Baked into Bonds

Plain and Simple: There was a larger than expected slowdown in 1st quarter growth, but the Fed believes those effects will prove "transitory" assuming continued improvement in household balance sheets, easing credit conditions, and strengthening labor markets. The economy appears to be gaining enough traction to support a MODEST recovery, but remains highly sensitive to a number of variables including a larger-than-expected drag on household and business spending from higher energy prices, continued fiscal strains in Europe, larger-than-anticipated effects from supply disruptions in the aftermath of the disaster in Japan, continuing fiscal adjustments at all levels of government in the United States, financial disruptions that would be associated with a failure to increase the federal debt limit, and the possibility that the economic weakness in the first quarter was signaling less underlying momentum going forward.

If the variables listed above do not slow the pace of economic expansion and growth resumes as anticipated in the second half of 2011, the Fed will likely be forced to begin the exit process from extremely accommodative policy.  In preparation for such a scenario, the Fed economic staff gave a presentation on strategies for normalizing the stance and conduct of monetary policy over time as the economy strengthens. This does not mean the move toward such normalization would necessarily begin soon, but it does describe the steps the Fed will take toward tightening in the context of the economic outlook and the Committee's policy objectives.

Most at Fed Want Rate Hikes Before Asset Sales: (Reuters) - Most Federal Reserve officials prefer to raise benchmark interest rates before selling assets when the time comes to tighten policy, minutes of their April meeting showed on Wednesday. During an extensive discussion of how the central bank might pull back its massive support for the world's largest economy, officials agreed they would eventual shrink the Fed's much expanded portfolio over the medium term, and that getting rid of mortgage-related debt would be a priority. "A majority of participants preferred that sales of agency securities come after the first increase in the (Fed's) target for short-term interest rates," the Fed said. And many of those participants also expressed a preference that the sales proceed relatively gradually, returning (Fed holdings) to all Treasury securities over perhaps five years," the minutes said.

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In the event the economy does begin to recover at a faster pace, one part of the exit process involves the Fed reducing the size of its balance sheet, which means selling their agency MBS holdings. Right now we don't see how the Fed will be able to off-load their MBS holdings if they raise rates first, not without taking a substantial loss. When the Fed is finally ready to start selling their MBS holdings, the market will have already pushed benchmark coupon yields above the MBS coupons owned by the Fed. That means there would be limited incentive for investors to buy agency MBS because their yields would be below the yields (underperforming) offered by RISK FREE (no embedded call) benchmark Treasuries. Therefore, the Fed will likely be forced to hold onto a large portion of their MBS portfolio to avoid shocking the market and losing a hefty chunk of change.