Fed may choose to keep its powder dry for 2012-end: Goldman

Political parties supporting Greece's international bailout will begin forging a government on Monday after an election victory over radical leftists staved off the prospect of the debt-laden country leaving the euro and brought relief to global markets.

German banks and fund managers welcomed the pro-euro, pro-bailout outcome of the Greek election but say the new government must quickly restructure the country without expecting many concessions from euro-zone partners on agreed austerity measures.

According to O'Neill, the case for a Fed easing in the FOMC meet is quite strong right now. However, he feels, the Fed may choose to keep its "powder dry" for 2012-end.

Fed chairman Ben Bernanke and the Federal Open Markets Committee (FOMC) meet Tuesday and Wednesday this week, amid fresh developments in the eurozone crisis and signs that the US economy is picking up.

The Federal Reserve kept interest rates at historic lows in the range between 0% and 0.25% in an attempt to increase consumption and business operations by making borrowing cheaper to revive the economy.

O'Neill believes the Greek outcome has reduced possibility of a coordinated action. He says the European Central Bank wants EU politicians to move on reforms before taking up any further easing. 

"I think the European Union situation will continue to determine global market moves," he told CNBC-TV18 in an interview.

As far as India is concerned, O'Neill feels, the country has "strong potential" but needs "urgent policy actions".

Below is an edited transcript of his interview with Udayan Mukherjee and Mitali Mukherjee. Also watch the accompanying video.

Q: What did you takeaway from the election outcome in Greece and do you think it has dramatically reduced the chances of a near term Greece exit from the euro?

A: The weekend results mean that the chances of a Greek exit in the near term has diminished considerably. I wasn’t sure what was going to happen this weekend, but I was reasonably sure that Greece wouldn’t leave in the near future.

Anyhow, Greece still has a primary budget deficit, the time where its more likely that they could decide to leave is late next year when we think they would be in primary budget surplus. But I think the election results over the weekend should calm people down about that part of the European crisis for a while. But unfortunately, there are plenty of other issues.

Q: The next big one is tomorrow, the US Fed meeting, and the street is divided on whether we will get some kind of quantitative easing or not. What are your expectations?

A: The Fed’s stance is pretty famous, pretty transparent. The economy has weakened, inflation has come down, and external risks are rising, so I think the case of the Fed doing something new is quite strong. The only downside I have in many ways is that I am not sure what traditional QE is going to do in the US. What has happened here in UK in past week, where the Bank of England announced something genuinely new and more imaginative is probably more the way to go.

It looks from the way the Fed’s talking that there are no real signs they want to do anything dramatic. That being said, the economy has only slowed a little and it has been growing close to 2.5% for a while, so maybe the Fed wants to keep some powder dry in the events of things getting worse down the road. I would be surprised if they don’t do little bit more this week.

Q: Most markets had about a 7-8% rally between the two Greek elections. If there is no word from the Fed come Thursday, which is when we will know about their decision, would you say it would be a halt to the rally we have seen so far?

A: We have got a lot of issues in Europe that we got to get through. As I said earlier, we have got a big meeting at end of month; that’s close to two weeks off still, but this sort of hangs over everything in the world. I am a person that travels extensively and literally everywhere I go the only thing people ask about is the European situation. What people know is that there is this big meeting and that’s where lot of volatility, uncertainty is coming from. So, I would be surprised if we had a significant rally in markets until we get more clarity there.

That being said, I do think people tend to overstate its importance. The world market rallies really come from the BRICs and the US. I do believe once we get beyond the summer in the latter part of the year the equity markets will rally again, but I am not sure if it’ll happen as soon as this week.

Q: Because of these constant doors of news flow that’s coming in from Europe, most of it is negative, would you expect things to remain volatile in the near term?

A: With what’s happening with Spanish and Italian yields, I think we need to have some thing big happening. Fortunately we have a big meeting coming up at the end of the month when the EU leaders get together, and later this week the four leaders of the big countries - Germany, Spain, France and Italy - all get together.

They need to do something, because as we go through time the crisis is getting bigger. As you can see with the Greek development and with the Spanish package last weekend, market relief rallies on good news just aren’t lasting anymore and that’s a bad sign. The markets want a bigger pan European solution and the only place that can provide that is Germany.

Q: So if the European situation were to worsen, do you expect some coordinated action by the central banks across Europe which might trigger off a rally?

A: I think in a strange way the Greek election outcome has reduced the probability of that. I think last week policymakers were highly concerned about some kind of very bad Greek outcome, the possibility of contagion and made it pretty clear that they were prepared in a co-ordinated manner to add liquidity. I think from the G20 statement tomorrow we might get a further reminder of that, but I am not sure in the near term we should expect anything dramatic from central banks around the world. Each will do what they think is right for their own local circumstances.

But there will certainly be in the events of markets turning down badly a changing situation where they would add more liquidity, but I think way things now stand I wouldn’t put too high hopes on that.

Q: Do you expect to see a rate cut from the ECB policy meet which is on the 5th of July? What specific kind of easing on action do you expect from the ECB between now and then?

A: I think the ECB has made it pretty clear in the past couple of weeks that they have this sort of slightly delicate situation where they don’t want to make it easy for Europe’s politicians. They have made it quite clear that Europe needs a medium to long term strategy of improving the Economic and Monetary Union (EMU) structure and therefore put it over to the politicians to deliver on that. So I can’t imagine the ECB doing anything until this big meet is out of the way.

After that I think the likelihood of some further easing in monetary policy from ECB rises significantly. The economies here are very weak in general and the ECB has a mandate it needs to fulfill, so I would expect some easing later on the summer but not before that summit.

Q: We have been through our own patch of bad news over here in India with lots of rating concerns and fears of a downgrade. Are they warranted you think? Has something significantly changed in India amongst the entire BRIC lot?

A: From where I sit as the so called Mr BRIC, I am rather pleased that the ratings agencies have been saying these things. India in many ways is, certainly in the past two years, has been the disappointing of the four BRIC countries. Yet, because of its demographics it has the best potential, but India can’t reach that potential just by assuming its going to happen.

Normally pressure from ratings agencies and pressure from financial markets usually end up getting some kind of policy response and maybe the markets and the ratings agencies need to do that because without that pressure it looks like Indian policymakers aren’t going to do things that that they should do. So I don’t know whether the ratings agencies are right with the degree of where they are going, but I welcome the comments they are saying because India needs to change.