U.S. Federal Reserve Announces it Will Sit on Sidelines

The Fed just finished its meeting and here is its current policy statement, along with its previous statement (4/27). I present the two statements on a paragraph-by-paragraph basis, and then intersperse my translation/commentary.

As was universally expected, there was no change in the 0 to 0.25% Fed Funds rate. QE2 is coming to an end, and there is no indication that they will move on to another round of large scale asset purchases, or QE3. However, proceeds from maturing securities will be reinvested, keeping the size of the Fed’s balance sheet unchanged.

“Information received since the Federal Open Market Committee met in April indicates that the economic recovery is continuing at a moderate pace, though somewhat more slowly than the Committee had expected. Also, recent labor market indicators have been weaker than anticipated.

“The slower pace of the recovery reflects in part factors that are likely to be temporary, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan. Household spending and business investment in equipment and software continue to expand. However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed.

“Inflation has picked up in recent months, mainly reflecting higher prices for some commodities and imported goods, as well as the recent supply chain disruptions. However, longer-term inflation expectations have remained stable.”

“Information received since the Federal Open Market Committee met in March indicates that the economic recovery is proceeding at a moderate pace and overall conditions in the labor market are improving gradually. Household spending and business investment in equipment and software continue to expand. However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed.

“Commodity prices have risen significantly since last summer, and concerns about global supplies of crude oil have contributed to a further increase in oil prices since the Committee met in March. Inflation has picked up in recent months, but longer-term inflation expectations have remained stable and measures of underlying inflation are still subdued.”

The Fed is painting a more subdued picture of economic growth than it did last time, but sees this as a temporary soft patch, not an overall loss of momentum. While I agree that some of the headwinds are not going to last, others — such as a concretionary fiscal policy at all levels of government — are likely to continue.

It also thinks the pickup in inflation we have seen so far this year is temporary. On that I tend to agree with them. Due to the recent drop in oil prices, it is very likely that we will get a negative headline CPI number in June. If anything, longer-term inflation expectations have been trending down in recent weeks.

“Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The unemployment rate remains elevated; however, the Committee expects the pace of recovery to pick up over coming quarters and the unemployment rate to resume its gradual decline toward levels that the Committee judges to be consistent with its dual mandate.

“Inflation has moved up recently, but the Committee anticipates that inflation will subside to levels at or below those consistent with the Committee’s dual mandate as the effects of past energy and other commodity price increases dissipate. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.”

“Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The unemployment rate remains elevated, and measures of underlying inflation continue to be somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate.

“Increases in the prices of energy and other commodities have pushed up inflation in recent months. The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations. The Committee continues to anticipate a gradual return to higher levels of resource utilization in a context of price stability.”

Not a lot of change here. The Fed tries to hit two targets: full employment and low inflation. It is missing very badly on the employment front. It has also been missing a little bit on headline inflation, but the core rate of inflation, which is more appropriate for setting monetary policy has actually been missing to the low side.

Combined, this would seem to make the case for more monetary stimulus. Since the Fed Funds rate is already as low as it can get, that would mean QE3. However, they fear they are facing diminishing returns from the policy, and in effect, pushing on a string.

On balance I would prefer to see more stimulus, but I understand their fears. Monetary stimulus is clearly a second-best option for getting the economy moving again. Fiscal stimulus would be more effective, but that runs counter to the whole debate in D.C. right now, which is over how fast we can implement a deeply concretionary fiscal agenda.

“To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent. The Committee continues to anticipate that economic conditions — including low rates of resource utilization and a subdued outlook for inflation over the medium run — are likely to warrant exceptionally low levels for the federal funds rate for an extended period.

“The Committee will complete its purchases of $600 billion of longer-term Treasury securities by the end of this month and will maintain its existing policy of reinvesting principal payments from its securities holdings. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.”

“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 continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and will complete purchases of $600 billion of longer-term Treasury securities by the end of the current quarter.

“The Committee will regularly review the size and composition of its securities holdings in light of incoming information and is prepared to adjust those holdings as needed to best foster maximum employment and price stability. 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 continue expanding its holdings of securities as announced in November.

“In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and will complete purchases of $600 billion of longer-term Treasury securities by the end of the current quarter. The Committee will regularly review the size and composition of its securities holdings in light of incoming information and is prepared to adjust those holdings as needed to best foster maximum employment and 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 for the federal funds rate for an extended period.”

QE2 is coming to an end on schedule, and the change in the language reflects that. The key “exceptionally low levels for the Fed Funds rate for an extended period” language was kept unchanged. This pretty much ensures that the rate will stay at the near zero level it has been at since December 2008 at least through the end of this year and possibly much longer than that. The first step towards tightening of monetary policy will be the removal of that language.

The next step would be for the Fed to let some of the assets they accumulated in the first two rounds of quantitative easing to roll off as they mature, thus gradually bringing down the size of the Fed Balance sheet. The third step would be to actually start selling some of those assets in the open market.

Only after all three of those steps are taken (or perhaps at the same time, as outright asset sales) will the Fed raise the Fed Funds rate. When the Fed does move on the rate it is likely to do so in a very gradual and measured pace. Low short-term interest rates are going to stick around for awhile.

“The Committee will monitor the economic outlook and financial developments and will act as needed to best foster maximum employment and price stability.”

“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.”

Just a minor change in the syntax, but not a big change in the message, which is pretty much boilerplate. It would be very big news if the Fed were not going to monitor the economic outlook and financial developments.

“Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; 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; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen.”

Everyone agreed with the decision, although I suspect that when the minutes come out in three weeks they will reveal some fairly vigorous discussion about monetary policy, and how and when to change the size of the Fed balance sheet.

Essentially the fed is saying that it is going to sit on the sidelines for the foreseeable future and see what happens. The Fed Funds rate is not going to change for a long time, and a third round of quantitative easing, or large scale asset purchases, is not very likely unless the economy and unemployment take a serious turn for the worst.

On the other hand, the Fed seems in no hurry to unwind the first two rounds of quantitative easing. Personally I would be inclined to see more easing, as I see the high unemployment rate as being a much bigger economic problem than current levels of inflation, and I don’t see a major threat of runaway inflation, particularly core inflation, anytime soon.

Bernanke will be holding a news conference this afternoon in which he will provide more color on the Fed’s thinking and in which he might reveal changes to the Fed’s forecasts for economic growth, employment and inflation. We will be watching and will provide another post if he says anything noteworthy.

Zacks Investment Research

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