The Fed Has Shifted Its Objectives
As some readers will note, I did not expect the Fed to engage in direct bond buying today. Instead, I proposed that the Fed would engage in one of several other possible easing actions. The reason for this assessment was that I assumed that FOMC policy was being dictated by:
- Concerns about the strength of the U.S. economic recovery, particularly as it pertains to employment.
- The Fed's goal to maintain low and stable inflation.
The Fed's announcement today indicates that these were not the primary objectives driving policy.
Just to be very clear, the Fed announced a couple of different policy objectives today. They will begin an unlimited duration bond buying program, involving the Fed purchasing $40 billion/month of mortgage backed securities (MBS). They also extended their guidance to maintain interest rates at or below 0.25%, at least through mid-2015. These policy changes are in addition to continued policies extending the maturity of its securities holdings ("Twist") and continuing to reinvest principle payments from holdings of MBS back into the MBS market. All told, the Fed will be pumping about $85 billion into the MBS market each month while creating continued downward pressure on interest rates through Twist (expiring at the end of 2012) and extended forward guidance into 2015.
The policy choice to engage in further asset purchases demonstrates that the Fed's goals have fundamentally shifted. While U.S. inflation and employment are nominally still their concern, one line in the press release indicates a more overtly global focus than the Fed has previously acknowledged: "Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook." This statement indicates that the Fed is deeply concerned about slowing growth in Asia and is now overtly pumping liquidity not just into the U.S. market, but the global economy.
These concerns about Asia also translate to currency concerns. In particular, China is likely to stop allowing the value of their currency to rise toward parity with the dollar, thus weakening the U.S. export economy. By injecting more liquidity into the market, the Fed has put downward pressure on the dollar to combat this problem and bolster U.S. manufacturing, and theoretically employment.
This downward pressure on the dollar serves another purpose as well, to monetize U.S. debt. A weaker dollar means that U.S. debt is worth less in real terms. Add in the low interest rates, and running huge government deficits almost looks like sound fiscal policy. I had previously assumed that the Fed was not overtly pursuing this strategy (although it has been discussed in academic circles for years), but today's announcement indicates that may have been a flawed assumption.
Essentially, the Fed spent trillions allowing businesses to deleverage in hopes that this would create a more sound banking sector and allow businesses to begin hiring. Unfortunately, the European crisis has scared businesses away from hiring and instead, they are sitting on huge cash reserves, waiting for the market to stabilize. I had previously assumed the Fed would pursue a policy of stimulating lending to increase employment and get this cash moving in the market, but they have decided on another strategy. This strategy involves driving the value of the dollar down to incentivize job creation in the U.S. and combat the Chinese policy of weak currency.
This shift to a global focus and efforts to monetize U.S. debt indicate that the Fed is not really aiming directly at jobs, but at the underlying factors that create jobs. Bernanke's press conference supports this view, as he made every effort to assure markets that he is trying to boost confidence, even if the Fed is unable to fix many of the remaining economic problems. Undoubtedly, some inflation hawks will say that this was Bernanke's plan all along, and it may have been, but prior to today, the indications did not point directly toward a weak dollar policy.
It is important to remember that a weak dollar does have some economic benefits for investors. In particular, this policy shift makes commodities, oil and gold -- all solid asset classes -- and suggests that the recent bull market trend in equities will likely continue. It is also worth noting that although the Fed extended their forward guidance into 2015 today, Bernanke's term as Chairman is up in January 2014 and a potential President Romney replacement would be unlikely to continue this policy. So, those assets reliant on low interest rates have a solid commitment through the next 15 months, but we will not know until after the election whether that commitment really extends beyond that point.