Fed seen renewing extended rate pledge

The U.S. Federal Reserve is expected to surprise no one on Wednesday by holding interest rates near zero and repeating its vow of an extended period of very low rates at the conclusion of a two-day policy meeting.

The Fed is looking for a yawn, said Torsten Slok, an economist for Deutsche Bank Securities in New York. They would like the market to say, 'Thank you, that is what we expected.'

The Fed is seen nodding to a firming of the economic recovery since its March meeting, perhaps noting steady gains in consumer spending.

With the Fed's purchases of mortgage-related debt completed and all liquidity programs except one aimed at commercial mortgage-backed securities closed, the U.S. central bank could comment on the improved functioning of financial markets.

However, most analysts believe it is too early to expect the Fed to suggest it is close to shrinking its massive balance sheet, which would signal a first step in tightening financial conditions.

Below are possible outcomes for the meeting.

--MAINTAIN EXTENDED PERIOD VOW; SIGNAL THAT RECOVERY,

WHILE WEAK, IS FIRMING.

Fed Chairman Ben Bernanke and Vice Chairman Donald Kohn have been cautious in their discussion of the recovery in public statements.

It looks like we're on a path to moderate recovery, Bernanke told Congress April 14. That being said, there are any number of things that could derail it.

The Fed has sought to disentangle itself from a commitment to any specific time lag before it raises rates when it drops the extended period language.

Some Fed officials had said the extended period suggested six months could pass before the Fed would raise rates, but minutes of the Fed's March meeting said a number of policy makers believe that policy should depend on what is happening in the economy and not be linked to any specific period of time.

Having made that clear, the Fed is unlikely to be in any rush to change the formulation, which would lead markets to begin pricing in rate hikes.

PROBABILITY: High

MARKET IMPACT: Negligible because widely expected based on Fed communications and data.

--MAINTAIN EXTENDED PERIOD LANGUAGE; CAST DOUBT ON THE

STRENGTH OF THE RECOVERY.

Fed officials have been worried that housing activity has been leveling off. There are also signs the recovery is concentrated in large companies rather than smaller enterprises, which account for a large number of new hires, leading to some concerns about the sustainability of the recovery.

PROBABILITY: Low. While subdued in their outlooks, most Fed officials believe the recovery has turned the corner.

MARKET IMPACT: The dollar could lose ground on worries about persistent U.S. economic weakness. Longer term bond yields could tick up on inflation worries.

--DROP EXTENDED PERIOD LANGUAGE; SIGNAL RECOVERY CLEARLY

ESTABLISHED.

The Fed could point to improvements in the labor market and evidence that industrial production is picking up to make the case that it needs the flexibility to react quickly to any surge in growth or spike in inflation.

PROBABILITY: Low.

MARKET IMPACT: Bond markets would quickly price in a series of Fed rate hikes. Stocks would likely rise on signs of resurgent growth.

(Reporting by Mark Felsenthal; Editing by Leslie Adler)