Tuesday, September 21, 2010

Thoughts on the Fed announcement

Data Release: Much of the same or is it?

· As expected, there were no major changes to the Federal Open Market Committee (FOMC) statement from their previous statement in August.
· The Fed maintained the target range for the federal funds rate at 0.0 to 0.25 percent and retained the reference that economic conditions warrant “exceptionally low levels of the federal funds rate for an extended period.” They also maintained their policy of reinvesting principle payments in treasury securities.
· The Fed did give a hint that further quantitative easing may be in the pipeline with a line that “the Committee…is prepared to provide additional accommodation if needed to support the economic recovery.”
· Another noticeable change was in their discussion of inflation, where they stated “measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the long run, with its mandate to promote maximum employment and price stability.” It also added that “inflation is likely to remain subdued…before rising to levels the Committee considers consistent with its mandate.”
· The statement also recognized that while “bank lending has continued to contract” this has been “at a reduced pace in recent months”
· Once again Thomas Hoenig dissented to both the policy to maintaining the extended language commitment as well as the policy of reinvesting principal payments.

Key Implications

· This statement makes clear that quantitative easing has not been taken off the table, but that it is not a sure thing either. There appears to be little consensus within the Fed on whether to go forward with additional asset purchases, which puts the onus on the economic data to either confirm the Fed’s expectations or push them towards further action.
· The recognition that the contraction in bank lending has eased in recent months should not be overlooked. The Federal Reserve is cognizant of the impact of financial conditions in either impairing or improving the transmission of monetary policy to the real economy. An improvement in credit growth implies less need for the Fed to step in with additional quantitative easing.
· By focusing on trends in inflation and recognizing that recent levels have moved below their implicit target, the Fed has signaled that inflation outcomes are likely to be the threshold that would move the Fed towards a second round of quantitative easing.
· It is telling that the Fed chose not to focus on downside risks to the economic outlook. This likely reflects a desire not to spook markets with disappointing expectations for future growth, while appearing vigilante in fighting deflationary expectations from becoming entrenched.
· Nonetheless, with economic growth likely to maintain at a sub 2.0% pace over the next several quarters, speculation about the Fed doing more to support growth will continue to be on the forefront of the agenda for the next several meetings.

James Marple, Senior Economist

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