As was widely (universally?) expected, the Fed kept the fed funds rate at a range of between 0% and 0.25%, where it has been since the height of the financial meltdown in 2008. Also, the “likely to warrant exceptionally low levels for the federal funds rate for an extended period” language was retained.
However, the big question that the market has been focused on is if we would get a second round of quantitative easing (a.k.a. QE2) and if so, how big the ship would be. The answer turns out to be yes, and will be a total of $600 billion between now and the end of the second quarter of 2011, or a pace of about $75 billion per month.
That is a bit smaller than what I and most observers were looking for. Below, I show the current Fed Policy statement, and the previous Fed Statement (9/21) on a paragraph-by-paragraph basis, along with my interpretation/translation.
“Information received since the Federal Open Market Committee met in September confirms that the pace of recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.
“Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters.”
“Information received since the Federal Open Market Committee met in August indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.
“Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts are at a depressed level. Bank lending has continued to contract, but at a reduced rate in recent months. The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be modest in the near term.”
Here is a very subtle difference between the pace of recovery “continues to be slow” and “slowed in recent months” as the current statement refers more to the level of activity than the direction of activity. I think that the current language is slightly more positive than the September language, but the difference is subtle, and certainly not dramatic.
Another positive change in the statement is that there is no further reference to bank lending contracting. The expectations of a gradual return to higher levels of resource utilization were moved to a different paragraph but remain. Resource utilization is “Fed speak” for employment and capacity utilization. The key word here seems to be “gradual” — as in gradually Los Angeles is moving northward and eventually become a suburb of San Francisco.
The context of price stability was replaced by language that indicates some concern that the current level of inflation is too low (and thus that deflation is a real threat, at least in the absence of action by the Fed). However, the stability of longer-term inflation expectations (one could quibble about the veracity of the statement given the spreads between regular T-notes and TIPS which have shown some lowering of longer-term inflation expectations in recent months) seems to indicate that this is only a temporary situation.
“Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.”
“Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.”
Normally there is a trade-off that the Fed has to make in its dual mandate. An easier monetary policy generally helps on the full-employment side, but hurts on the inflation side, and vice versa. That is not the case today as the economy is running too cool on both fronts.
The problem is that the Fed long ago used up all of its conventional ammo, namely lowering the Fed Funds rate. It is already effectively at zero, and it can’t go negative. Thus it is forced to turn to unconventional methods, namely going out and buying longer-term assets, in this case T-notes) and paying for them with money it creates out of thin air.
This increase in the money supply has the risk of causing inflation, but given the huge amount of slack in the economy, that is not much of a risk in the short run. A little bit more inflation would actually be helpful as it would lower real interest rates.
“To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings.
“In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.”
This is the “money shot” of the release. The overall size of the program is about what I expected, but it is over a somewhat longer time frame. I was looking for a pace of about $100 billion per month, but with an initial term of six months or so. However they did put in language which will allow them to be flexible on the pace of the purchases.
“The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.”
“The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period. The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings.”
Mostly this is unchanged from the last meeting. For some time, this was the key paragraph that everyone has been looking at, since it has the “exceptionally low level…extended period” language. By pledging to keep short-term rates low for a long time, the Fed can also lower longer term rates.
After all, if you have a sum of money to invest for say to years, you could either: A) invest in a two year note, or B) in a one year note, and buy another one year note a year from now. By promising that the one-year rate will be low a year from now, it drags down the rate on the two year note (and obvious permutations for different maturities, as the fed funds rate is a very short term rate, not a one-year rate, but the same principal applies). This sort of jawboning is one of the tools available to the Fed once it hits the lower limit of zero on the actual Fed Funds rate.
“The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.”
“The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.”
The standard boilerplate saying that they are not just going to hit the golf course between meetings was retained. One would hope that they would continue to monitor the economic outlook — that is, after all, a big part of their job.
A very subtle change to “employ its policy tools” from “prepared to provide additional accommodation.” However, the QE2 program is the additional accommodation that they were talking about in the last meeting. I would not read that to imply that they might be using their tools to tighten policy anytime soon.
“Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Sarah Bloom Raskin; Eric S. Rosengren; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.
“Voting against the policy was Thomas M. Hoenig. Mr. Hoenig believed the risks of additional securities purchases outweighed the benefits. Mr. Hoenig also was concerned that this continued high level of monetary accommodation increased the risks of future financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy.”
“Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.
“Voting against the policy was Thomas M. Hoenig, who judged that the economy continues to recover at a moderate pace. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and will lead to future imbalances that undermine stable long-run growth. In addition, given economic and financial conditions, Mr. Hoenig did not believe that continuing to reinvest principal payments from its securities holdings was required to support the Committee’s policy objectives.”
Two of the empty slots on the Fed board were filled between the two meetings; the third nominee, Peter Diamond — the 2010 Nobel Prize in Economics winner — was held up by the GOP in the Senate, although the nomination has been resubmitted.
Tom Hoenig has been dissenting all year, arguing that the economy does not need any more monetary stimulus and that providing it is dangerously inflationary. Fortunately he is in the minority.
QE2 should help the economy, but just a little. The economy is hurting and could use a shot of morphine. QE2 is the equivalent of aspirin. It will help a little bit, but not nearly enough, and poses some other risks. What the economy really needs is more fiscal stimulus, but that is not likely to happen, especially after last night’s midterm election returns. However, if morphine is not available, you may as well try the aspirin.
One of the most likely effects is that it should weaken the dollar, and that will help the trade deficit. A weaker dollar will make imports more expensive, and our exports more competitive. The higher prices for imports is inflationary, but inflation is not much of a problem right now.
Buying up T-notes also lessens the cost to the Treasury of the national debt, since the interest payments on the notes bought get paid to the Fed, and then the Fed rebates them to the Treasury. In effect, this is monetizing the debt. Then again, even the currency in your pocket is a form of debt by the government, that is the “note” part of “Federal Reserve Note.” Currency, however, does not pay any interest, while T-bills and T-notes do. At this point, with rates as low as they are, that is a distinction without much of a difference.
Thus at one level QE2 is simply a shift in the maturity structure of the debt. The buying pressure by the Fed — after all, even in a deep and liquid market like that for T-notes, $75 billion per month is not exactly chump change — should help to lower longer-term interest rates. However, to the extent that the bigger money supply helps drive up inflation expectations, that effect could be offset.
If you are locking up your money in a 10-year T-note, the average level of inflation over the next ten years matters a great deal to your real return. The current level of the 10-year note of around 2.6% already implies very low levels of expected inflation over the next decade. Thus the downward pressure on longer-term rates from QE2 could very well turn out to be very short lived.
QE2 does, however, more or less eliminate the threat of deflation. Deflation is a very serious problem if it is allowed to take hold. It causes consumers to sit on their wallets waiting for lower prices, and as a result demand falls. That results in a fall in production and employment.
At the same time, debtors find it harder to come up with the cash they need to service their debts. The flip side of that is that creditors now find that the interest payments they get can buy more goods and services. That might sound like a wash, but it really isn’t — creditors tend to suffer many more defaults in a deflationary environment.
The QE2 was widely expected, and was somewhat smaller than the market generally seemed to be expecting, thus is a bit of a disappointment, but not a huge one.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
