2 Sep 2011


August appears like it may be a pivotal turning point in economic trends after a slew of economic data released draws a picture of an economy in peril. Consumer confidence numbers disappointed this morning, housing, employment and inflation are all looking poor, yet the ultimate question is how will the Federal Reserve react. Let’s see what we learned from the Fed this month:
The month of August kicked off with the Federal Reserve debating how to deal with a weakening stock market and disappointing economic results. This lead to the Fed’s monthly policy release stating that they would commit to keeping interest rates between 0-0.25% until at least mid-2013. This replaced the former language which just stated the Fed would keep interests rates low for ‘an extended period’. There were three dissents among Federal Open Market Committee members, the most dissents in almost 20 years, as doubts over the Fed tying their hands to a loose policy disturbed the more hawkish Fed members.
The meeting’s minutes were released yesterday and gave us a deeper insight into the decision, most important being the committee’s commitment was meant to be conditional. From the minutes,
“Most members, however, agreed that stating a conditional expectation for the level of the federal funds rate through mid-2013 provided useful guidance to the public, with some noting that such an indication did not remove the Committee’s flexibility to adjust the policy rate earlier or later if economic conditions do not evolve as the Committee currently expects.
The Fed also indicated more easing can be expected if growth disappoints and, in a traditional ‘setting oneself up for failure’, the Fed’s expectations for GDP are unrealistically high:
Short-term growth is likely to disappoint with housing remaining in a rut, inflation being high, fiscal balances are tapped out, and given the lack of capital inflow to the US after this month’s disappointing TIC data, the Fed is almost certainly going to step in.
Many have speculated that easing will be seen in the form of a long-rate-biased maturity shift in the composition of the Fed’s balance sheet, also known as “operation twist”. Since the Fed has already secured short-rates by committing to keep the overnight rate at its historical low, “operation twist” would lower long rates without growing the Fed’s balance sheet, by effectively swapping short-maturity assets for long ones. The Fed has already biased their purchases towards the long-end of the yield curve, when they went on a mass scale purchase of mortgage-backed securities followed by mid to long term treasury bond purchases. Because of the Fed’s current heavy weighting to long-maturing assets, the fact long rates are already very low, and funding shortages could still develop, some Fed members have argued that this type of program would not be very effective.
A different option which seems to have more support in the Fed is another quantitative easing program, in contrast to the qualitative loosening just mentioned, commonly dubbed ‘QE3′. This would involve a strong outright expansion of the Fed’s assets after being purchased with printed money. The main point of significance, should more easing occur just because of faltering growth, is markets will interpret the signal as the Fed having lost any care for controlling their inflation appetite. The current inflation rate is already almost twice as much as the Fed’s 2% target:
Even the Fed’s preferred inflation gauge, the PCE deflator, just had its annual reading as of July recorded at 2.8% – well above the Fed’s target. The only measure the Fed can rely on to keep up the nonsense they preach about inflation expectations being stable, is the TIPS spread. However, as we discussed here, the TIPS spread is not a market sentiment indicator since the Fed is the biggest player in the Treasury market, thereby shaping and distorting those expectations.
Fed Chairman Ben Bernanke has signaled in the past that deflation would need to be present before he could justify another QE program. Currently the economy is operating at relatively low rate of capacity utilization, though its on the rise back up, yet inflation, as already mentioned, is very high and so is unemployment. This should put a nail in Bernanke’s theoretical models, but even he cannot stay consistent if he turns to growth as the impetus for another balance sheet expansion. Gold can be expected to perform very well on news that the Fed is formally and publicly furthering the use of the printing presses to defend growth without concern for inflation.
Other easing options which the Fed has mentioned include committing not only to keeping interest rates low, but also securing the size of their balance sheet by commitment. The Fed has already communicated this fact well despite doing so in less formal settings, so the impact of announcing a formal commitment is likely to be negligible.
A last popular move which could be implemented is a lowering of the target range from 0-0.25% down to 0%. Effectively this would amount to about an eighth of a point cut in the effective federal funds rate – not much more support to borrowers. This would help the Fed however, as the interest they pay is an expense, and this decrease in their cost of funding would bolster their balance sheet’s status. Even small changes in the rate the Fed pays on excess reserve balances is significant, as the size of these reserves is at a record high:
Interestingly, even though this policy would make it cheaper for banks to borrow, the size of the Fed’s balance sheet would not grow as much as otherwise, implying a relative tightening, and banks would lose the income generated on their reserves

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