The Federal Reserve decided to keep the Federal Funds rate unchanged at the meeting it concluded today, as expected. Below is the current Fed Statement along with the one from their September meeting in paragraph-by-paragraph format, with my translation and commentary interspersed.
As the graph below shows, the market is expecting the Fed to remain on hold, with Fed Funds between 0 and 25 basis points for an extended period. The graph shows the expected outcomes for the January meeting (before today’s announcement) from the Cleveland Fed. The market set the odds of anything other than standing pat at either today’s meeting or the December meeting effectively at zero.
Reading off the chart, it looks like about a 95% probability of no action in January as well. I doubt we will see the Fed raise rates before the third quarter of 2010.
The Fed is playing out exactly the script that Ben Bernanke suggested in his academic work prior to joining the Fed: keep rates near zero, promise to keep them there for an extended period of time to help bring intermediate term rates low, and if needed use quantitative easing to increase the money supply in the event of a liquidity trap.
The Fed will first stop the quantitative easing (the buying of long-term treasuries and mortgage paper) before it considers raising rates. It is done with its program of buying $300 billion of long-term T-notes, and will finish up its $1.25 billion MBS buying program by the end of the first quarter. It slightly reduced its plan to buy agency debt from $200 billion to $175 billion.
“Information received since the Federal Open Market Committee met in September suggests that economic activity has continued to pick up. Conditions in financial markets were roughly unchanged, on balance, over the intermeeting period.
“Activity in the housing sector has increased over recent months. Household spending appears to be expanding but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth and tight credit. Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.
“Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.”
“Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn. Conditions in financial markets have improved further, and activity in the housing sector has increased.
“Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth and tight credit. Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.
“Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.”
The Fed sees more improvement in the economy. Most notably, it points out that household spending is increasing, rather than stabilizing as it saw in the last meeting — although due to the all the factors it pointed to last time, it is going to be a rather sluggish pick up.
Conditions in the Financial markets, by which they mean things like the rates that banks charge each other in the overnight funding market (the TED spread) had already returned to pre-crisis levels by the time of the last meeting, so there was not a lot of room for further improvement. Business investment is still sluggish, which is not a surprise given that capacity utilization is still around 70%, well below the lowest point reached in any recession since they started tracking capacity utilization in 1967, but up a bit from its low of near 67% in June.
The Fed thinks its policies are working, but that growth is going to be slow for the foreseeable future. I have to agree with them on that. Historically, capacity utilization of 80% is normal, and of 75% represents a deep recession. Capacity utilization of 85% or more represents a boom and signs that the economy is overheating, and needs to be reigned back in by higher interest rates. We are a long way from there.
“With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.”
“With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.”
Not a syllable changed from last time. Inflation is not a problem, and it will not be for some time to come. The reason is that with high unemployment, there is no way for the wage side of a wage price spiral to gain any traction. With almost 30% of the country’s factories, mines and power plants sitting idle, businesses do not want to risk losing market share by raising prices aggressively.
“In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. 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 of the federal funds rate for an extended period.
“To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. The amount of agency debt purchases, while somewhat less than the previously announced maximum of $200 billion, is consistent with the recent path of purchases and reflects the limited availability of agency debt.
“In order to promote a smooth transition in markets, the Committee will gradually slow the pace of its purchases of both agency debt and agency mortgage-backed securities, and anticipates that these transactions will be executed by the end of the first quarter of 2010. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.”
“In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. 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 are likely to warrant exceptionally low levels of the federal funds rate for an extended period.
“To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt. The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010.
“As previously announced, the Federal Reserve’s purchases of $300 billion of Treasury securities will be completed by the end of October 2009. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet, and will make adjustments to its credit and liquidity programs as warranted.”
The same basic idea in both statements, although the Fed did elaborate more on why they will keep rates low for an extended period. In other words: “Mr. Market, we mean it when we say we are not going to raise rates any time soon.”
The Fed did back off its quantitative easing program slightly. It is done with the program of buying $300 billion of longer-term T-notes, and is continuing its program of buying $1.25 trillion of mortgaged-backed securities. It did, however, slightly reduce its planned purchases of Fannie (FNM) and Freddie (FRE) debt, from $200 billion down to $175 billion. In the overall context of the quantitative easing program, the reduction is trivial. It is, however, a sign that the program will not be expanded, nor is it likely to be renewed after the current program is completed by the end of the first quarter.
“Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.”
“Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.”
Everyone agreed at both meetings. There had been a few Fed types who had been making speeches about the need to bring things back to normal sooner rather than later, but when the rubber hit the road, they are still on board with the program.
Overall, the Fed seems to understand that the weak economy is the overriding problem. Yes, things are getting better, but given the sluggish pace of improvement, this is not the time to be taking away the punch bowl.
This would be in keeping with historical precedent as I pointed out here. Following the end of the 2001 recession, the Fed waited 32 months before it started to raise rates, and then it did so at a very gradual 25 basis points at a time. Following the 1991 recession it waited 35 months.
So assuming that the NBER eventually determines that the recession ended in July 2009, history suggests that the Fed will not begin to raise rates until the first quarter of 2012. The last two recessions were far milder than this one, which would argue that the Fed should stay on easy street for even longer this time around.
The problem is that keeping rates so low for so long the last time was a key factor in allowing the housing bubble to form. Still, the balance of risks seems to be on the side of an economic relapse, not of an overheating that causes inflation to soar.
Keeping rates low means that we will have a steep yield curve. A steep yield curve allows banks to make a lot of money, since their economic function is to borrow short term, and lend long term. The idea is that if the curve is kept steep enough long enough, even basket-cases like Citigroup (C) and Bank of America (BAC) will be come solvent again.
The promise of keeping rates low for a long time should also put more pressure on the dollar, which would be good for improving our trade deficit — although at the risk of higher inflation, particularly headline inflation — since oil prices will go up at the dollar goes down. However, given the low inflation pressures elsewhere in the economy, it really is not that big of a risk.
Read the full analyst report on “FNM”
Read the full analyst report on “FRE”
Read the full analyst report on “C”
Read the full analyst report on “BAC”
Zacks Investment Research
