FOMC STATEMENT AND ANALYSIS

by Cullen Roche

Here’s the full FOMC statement. I highlighted a few pieces which I’ll discuss below:

For immediate release

Information received since the Federal Open Market Committee met in August indicates that economic growth remains slow. Recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated. Household spending has been increasing at only a modest pace in recent months despite some recovery in sales of motor vehicles as supply-chain disruptions eased. Investment in nonresidential structures is still weak, and the housing sector remains depressed. However, business investment in equipment and software continues to expand. Inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks. Longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect some pickup in the pace of recovery over coming quarters but anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. 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. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.

To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. In addition, the Committee will maintain its existing policy of rolling over maturing Treasury securities at auction.

The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and 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.

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 its tools as appropriate.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action were Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, who did not support additional policy accommodation at this time.”

The biggest announcement in this statement is “significant downside risks” to the economy. The Fed is becoming increasingly aware of their impotence. This could actually prove to be positive as Bernanke is likely to lean increasingly on Congress for aid in his fight against unemployment. But let’s not jump to conclusions. The bottom line is, this economy is very weak and is likely to remain so regardless of what the Fed does.

Operation Twist was basically as expected. They are buying $400B in long bonds and selling $400B in short bonds. It’s balance sheet neutral. Not that this matters a whole lot. As I’ve previously stated, monetary policy works by targeting rates. The Fed would have needed to say, “we are a buyer of 10 year bonds at 1%” in order for this to “work”. They didn’t do that. So, we can expect a lot of shuffling of the Fed’s balance sheet, but ultimately, these transactions lack a real transmission mechanism through which they can impact the real economy. In other words, this program should NOT put downward pressure on longer-term interest rates and SHOULD NOT help make broader financial conditions more accommodative.

The MBS purchases are interesting and they’re a slight change from past policy. I discussed this last year when I said this was one of the eventualities of QE2:

“He [Ben]wants to be fully prepared in case the banks relapse so he can step in with a sizable bank bailout. So, don’t be one bit surprised this week when Mr. Bernanke announces a small round of Treasury purchases with the option to buy MBS in the future. In all likelihood, this program will remain open until it’s clear that the U.S. economy is sustaining recovery and another bank meltdown is off the table. Don’t be fooled into thinking that this is some economic panacea.”

The Fed is likely disturbed by the recent house price declines and the deterioration in credit markets. As we saw during QE1, MBS purchases are an effective form of fighting a potential balance sheet deterioration and credit crisis. In this regard, the Fed appears proactive. That’s a positive. On the other hand, we shouldn’t sugarcoat this – this helps the banks and not the consumer via the mortgage market as the Fed press release implies – and yes, this is still a consumer driven balance sheet recession and NOT a banking crisis. The MBS purchases don’t generate economic growth, but could possibly help fend off credit fears. Unfortunately, the repurchases aren’t large enough to move the needle much.

In sum, this policy change doesn’t change much if anything. The Twist won’t “work” in reducing rates and the MBS purchases are an interesting and possible effective proactive measure (but not a growth measure!). The most interesting part of the statement is the “significant” economic downgrade. Ironically, the Fed might get their lower rates via a worsening economy and the lack of effective policy. The 10 year is dropping to 1.87% as I type!!

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