Federal Reserve: Twist It Is

by: Tim Duy

The FOMC just released its statement, dashing hopes for QE3. We are still waiting on the press conference, but some quick thoughts. First, the Fed does not appear to be particularly worried by recent weak data:

Information received since the Federal Open Market Committee met in April suggests that the economy has been expanding moderately this year. However, growth in employment has slowed in recent months, and the unemployment rate remains elevated. Business fixed investment has continued to advance. Household spending appears to be rising at a somewhat slower pace than earlier in the year. Despite some signs of improvement, the housing sector remains depressed. Inflation has declined, mainly reflecting lower prices of crude oil and gasoline, and longer-term inflation expectations have remained stable.

I suspect that the weak tone to recent data was countered by the relatively solid anecdotal tone of the Beige Book. The Fed does not appear to have marked down its forecasts as substantially as many believed. Also, it may want additional data to confirm any recent weakness.

Second, the Fed continues to state the case for more easing:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects economic growth to remain moderate over coming quarters and then to pick up very gradually. Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee anticipates that inflation over the medium term will run at or below the rate that it judges most consistent with its dual mandate.

Yet, despite making a clear case for aggressive policy, the Fed still doesn't follow things to their logical conclusion. This is indeed maddening and is the primary reason market participants expect sizable QE is coming. The FOMC sets ups the justification for easing meeting after meeting, and then simply does not deliver.

Third, consider the final line:

The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.

Now compare it to April:

The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability.

In April, the Fed specifically pointed to the balance sheet as the tool of choice. Now it just promises further action. Sounds like the Fed intentionally wants to take the focus off the balance sheet. This could be a very important signal about the direction of future policy. Do Fed governors view further QE as largely ineffective given low interest rates and constrained credit channels, and now reserve its use for only the most dire circumstances? If not the balance sheet, then what? Communication? Perhaps I am reading too much into this line, but it seems to be a significant change. I sure hope some reporter asks about this line at the press conference. Hint, hint.

Finally, we still have a dissenter, Richmond Federal Reserve President Jeffrey Lacker. The tone of the data was insufficient to change his mind that Operation Twist should end as scheduled.

Bottom Line: Internally at the Fed, the risk/reward trade off still does not favor additional QE.