Fed Watch: Weak Medicine

The Federal Reserve pronounced on the state of the economy, and the assessment wasn’t pretty.  I think this was pretty much the only good news:

However, business investment in equipment and software continues to expand.

We’ll see if that holds up given the downdraft in the economy. Speaking of that downdraft, the growth outlook pushes back the return to full employment:

The Committee now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting and anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate.  Moreover, downside risks to the economic outlook have increased.

And that hawkish inflation story is falling apart:

The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate as the effects of past energy and other commodity price increases dissipate further.

In response to these clear and present dangers to the economy, policymakers offered this:

The Committee currently anticipates 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 at least through mid-2013.

Not exactly shock and awe.  And this takes some of the fun out of Fed watching.  What will become of us if the Fed starts telling everyone the policy path for the next two years?  I imagine we will preoccupy ourselves with this:

The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability.  It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.

We can do more, but we won’t.  And why not?  I think the answer was back up in the first paragraph:

Longer-term inflation expectations have remained stable.

The story from the Treasury rally is more of a low growth than a deflation story.  In what world would anyone foresee that real 5 year yields would be negative, real 10 year yields would be zero, and the real 30 year yield just 1.06 percent?  If this really represents annual potential growth over the long run, the next few decades are going to be no fun at all.

Now, I think it is perfectly reasonable to argue that low growth will eventually work its way into substantially lower inflation expectations, and it would be better to get ahead of that curve.  The Fed doesn’t see it that way.  They will need to see inflation expectation numbers turn more solidly south to bring out another round of QE3.  I think that takes some additional weakness on top of what we are currently experiencing.

As far as the expectation of near zero rates for two years, is this weak or strong medicine?  My initial reaction was similar Paul Krugman’s:

The Fed didn’t announce a new policy. And despite what some press reports said, it didn’t even commit to keeping rates low; all it did was say that if the economy stays weak, rates will stay low — well, duh…

The Fed did not actually promise to keep rates low (whether market participants caught that nuance is another matter).  They only said that based on what they see now, they would anticipate zero rates for another two years. And so what?  We were going to figure that out sooner than later.  The expected date of the first rate hike of the cycle has been repeatedly pushed back “another six months.”  And, sure, with mere words the Fed can flatten the near term portion of the yield curve to nearly zero, but there wasn’t a lot of room to play around there to begin with.

Still, upon reflection, I see some additional upside from this psuedo-commitment.  In effect, the FOMC publicly marginalized the hawks.  You know who I am taking about:

Voting against the action were: Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, who would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an extended period.

Awfully convenient to have a block of three dissenters – the names “Larry, Moe, and Curly” come to mind.  But I digress.  One complaint over the past two years is that Fedspeak turns prematurely hawkish.  The instant one good month of data rolls through the door, the more hawkish policymakers rush to let market participants know the end of easy money is near, talk that induces a tightening as agents hedge their dovish bets.  Now we know not to be distracted by such talk, that while the bar to QE3 might be high, so too is the bar to actually raising rates.  In other words, while not a promise, the Fed’s outlook  works to entrench expectations against any misunderstandings caused by Fed hawks.

Bottom Line: All in all, this is pretty weak medicine given the condition of the patient.  I would have preferred to see an open-ended commitment to asset purchases – buying up anything not nailed to the floor at a rate of $10 or $15 billion a week until achieving the dual mandate is in clear sight.  But policymakers, on average tend to think they have relatively weak ammunition to stimulate growth.  Their tools are more effective against deflation.  And until the former turns into the latter, expect the Fed to do little more than modifications of the basic zero interest rate / hold balance sheet constant policy combination.

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