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The Federal Reserve's language lessons

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[December 13, 2014]  By Rodrigo Campos
 NEW YORK (Reuters) - "Will they or won't they?" is the question on investors' minds as the Federal Reserve policy-setting committee meets next week for the last time this year.

Markets have followed Fed speakers closely in recent weeks for clues on whether the U.S. central bank will change key language in its post-meeting statement regarding how long it will keep benchmark interest rates near zero.

Some expect the Fed to remove the reference to "considerable time" when setting a time frame for near-zero rates and maybe replace it, as it did ahead of the 2004-2005 monetary policy tightening cycle, with a nod to being "patient".

But that belief has been complicated somewhat by the slump in oil prices <LCOc1> <CLc1> that has pulled inflation expectations lower and caused the S&P stock index <.SPX> to post its first negative week in eight on Friday. The expectation of lower inflation could prevent the Fed from changing its current stance.

Client notes from Goldman Sachs, Citi and Bank of America/Merrill Lynch this week deal with expectations for the removal of the wording, roughly agreeing that however close the call is, it is more likely than not that the phrase will go away.

"They are going to remove it; I donít think (Fed Chair Janet Yellen) is going to keep it in there just because of what we are seeing with the energy sector," said Sean McCarthy, regional chief investment officer for Wells Fargo Private Bank in Scottsdale, Arizona.

"All the other data has been strong, whether you are looking at construction, at the ISM numbers, and especially the jobs data that she cares about most."

Indeed, recent statements from Fed officials suggest the language could be changed. Goldman Sachs, in a note, pointed to "widespread use of the word 'patient'" as a signal that "some participants would prefer to revise the current language."

The lack of consensus on the Fed's move all but guarantees that whatever the Federal Open Market Committee's statement says on Wednesday the stock market will be volatile, as it usually is on Fed decision days.

"The goal," said the BofA/Merrill note, "will be to smooth the marketís reaction. The Fed does not intend to signal a fundamental shift in policy, and we expect chair Yellenís press conference remarks to reinforce this point."

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The FOMC meets on Tuesday and Wednesday with a statement and forecasts expected Wednesday at 2:00 p.m. EST (1900 GMT), followed by Yellen's press conference half an hour later.

Markets are pricing in a disinflationary environment in the next few years. Short-term inflation expectations as measured by the yield gap between five-year Treasury Inflation Protected Securities (TIPS) <US5YTIP=TWEB> and regular five-year Treasuries <US5YT=RR> fell to 1.16 percent on Friday, the lowest in nearly 4-1/2 years, Tradeweb and Reuters data showed.

"There is no pressure out there to get ahead of inflation because there is no inflation out there," said Terry DuFrene, global investment specialist at J.P. Morgan Private Bank in New Orleans.

Yellen is seen as erring on the side of being too dovish rather than risking a move that comes in too soon and, compounded with the soft data out of the euro zone, Japan and China, adds to the risk of a slowdown in the U.S. economy.

However fed funds rate futures also show that the market expects a rate hike at some point in the third quarter of next year. The Fed is faced with the need to be slightly more hawkish in order to marginally move towards starting the tightening cycle.

(Reporting by Rodrigo Campos Additional reporting by Chuck Mikolajczak; Editing by James Dalgleish)

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