The Fed Stays on Hold

As was nearly universally anticipated, the Federal Reserve kept the federal funds rate unchanged at a range between 0.0% and 0.25%. There really is no way to cut the rate further since we are already at zero. Raising rates with no evidence of inflation and the economy operating far below its potential would be, in a word: stupid.

Below I present the current policy statement and the policy statement from their last meeting on August 10th, along with my translation/commentary on a paragraph by paragraph basis.

“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.”

“Information received since the Federal Open Market Committee met in June 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; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Bank lending has continued to contract. Nonetheless, 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 more modest in the near term than had been anticipated.”

Almost the same word for word, but they do note that business investment on equipment and software has slowed from the very robust rate we saw earlier in the year. The committee did not consider the 10.5% increase in housing starts that was announced this morning, but even with the bounce, their statement about the level of housing starts being depressed still holds. In short, they see slow — but positive — economic growth. That is pretty much what they saw at the last meeting.

“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.”

“Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.”

The real threat is deflation, not runaway inflation. That is certainly the message that the bond market has been sending with the yield on the 10-year T-note now at 2.59%. Any inflation of note over the next 10 years would quickly turn a T-note from a safe investment into a certificate of confiscation.

I really don’t know where they come up with long-term inflation expectations being stable; the implied inflation from the spread between inflation protected 10-year TIPS and regular 10-year T-notes has plunged in recent months, but then again so has the real interest rate. That part of the statement is at best disingenuous.

“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.”

“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 help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature.”

No big surprise here — the key language of “warrant exceptionally low levels of federal funds for an extended period” was maintained, as was the Fed Funds rate. They reaffirmed that they will not allow a passive tightening of monetary policy to occur due to the run off of their big mortgage paper portfolio.

The big question going into the meeting was if they would go further and actually increase the size of the Fed balance sheet. They did not, but the option still appears to be open. I would urge them to be more aggressive with quantitative easing. The downside to it is potential inflation, but again the real danger for the short- to intermediate-term is deflation, not inflation. On the other hand, when already up against the zero boundary and the economy in a liquidity trap, aggressive monetary policy will only help at the margin.

Additional fiscal stimulus would be far more effective. The first round worked well, but was too small given the scale of the problem. Cutting back spending now to try to cut the budget deficit is a huge mistake and is likely to further weaken the economy, and as a result cause tax revenues to fall. Thus will not even be all that effective in reducing the budget deficit, particularly as measured as a percentage of GDP.

“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 Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.”

Standard boilerplate about monitoring economic conditions. However, the additional accommodation phrase explicitly leaves open the possibility of more quantitative easing in the future. My question for Bernanke is this: With unemployment at 9.6% and factory utilization at just 72.1%, with no inflation to speak of, what the heck are you waiting for?

“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.”

“Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.

“Voting against the policy was Thomas M. Hoenig, who judges that the economy is recovering modestly, as projected. 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 limits the Committee’s ability to adjust policy when needed. In addition, given economic and financial conditions, Mr. Hoenig did not believe that keeping constant the size of the Federal Reserve’s holdings of longer-term securities at their current level was required to support a return to the Committee’s policy objectives.”

Everyone but Tom Hoenig agreed. Apparently Mr. Hoenig is not aware that the mandate of the Fed is to promote full employment as well as price stability. Either that of he thinks that 9.6% unemployment is something close to full employment. Mr Hoening is dangerously misguided. Fortunately, he will no longer be a voting member of the Open Market Committee next year.

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