Translating the Fed's Latest Policy Statement

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Includes: AGG, DIA, SPY
by: Zacks Investment Research

By Dirk van Dijk

The Federal Reserve once again left the Fed Funds target in a range between 0 and 0.25%, just as everyone expected. Below is the current Fed policy statement (in bold), along with the one from its meeting on March 16th (in italics), on a paragraph by paragraph basis. My interpretation and translation from "central bankerese" is interspersed.

"Information received since the Federal Open Market Committee met in March suggests that economic activity has continued to strengthen and that the labor market is beginning to improve. Growth in household spending has picked up recently but remains constrained by high unemployment, modest income growth, lower housing wealth and tight credit.

"Business spending on equipment and software has risen significantly; however, investment in nonresidential structures is declining and employers remain reluctant to add to payrolls. Housing starts have edged up but remain at a depressed level.

"While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability."

"Information received since the Federal Open Market Committee met in January suggests that economic activity has continued to strengthen and that the labor market is stabilizing. Household spending is expanding at a moderate rate but remains constrained by high unemployment, modest income growth, lower housing wealth and tight credit.

"Business spending on equipment and software has risen significantly. However, investment in nonresidential structures is declining, housing starts have been flat at a depressed level, and employers remain reluctant to add to payrolls.

"While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability."

The Fed is taking a slightly more upbeat view of the economy in this meeting than it did in the last meeting, most notably seeing actual improvement in the labor market rather than just stabilizing. As for household spending, I’m not sure if “picked up recently” means faster than “expanding at a moderate rate,” although the data we have for retail sales suggests that people are spending more freely now than they were a few months ago. This seems particularly true of big ticket items like cars and appliances, which indicates a more confident consumer.

The factors that they cite constraining consumer spending are the same ones they mentioned last time around. The language on Business spending is unchanged, but still positive, on-balance.

Their take on the housing situation is slightly more positive, as it should be due to the big jump in New Home Sales in March, as well as the upward revision to the dismal numbers for February. However, part of the 26.9% jump in home sales in March was probably due to the end of the homebuyer tax credit at the end of April (which will probably result in strong sales in April as well, but then a possible big drop in Many and June).

Also, the February numbers were probably weather constrained. New Home Sales are key to seeing housing starts rise, since they would just go into inventories if sales were not going up, and at least relative to sales, inventories remain high.

No change in their view of bank lending or the gradual move back towards more full use of both our human and physical resources as reflected in the unemployment rates, and the levels of capacity utilization, respectively.

"With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time."

"With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time."

No change at all. Inflation is not a problem now, and is unlikely to be one anytime soon.

"The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

"The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability."

"The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

"To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve has been purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt; those purchases are nearing completion, and the remaining transactions will be executed by the end of this month.

"The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability."

The keeping of the phrase “are likely to warrant exceptionally low levels of the federal funds rate for an extended period” is key. This means that we will in all probability not see an increase in the Fed Funds rate until at least the end of the year. Aside from taking out references to the purchases of agency debt and agency mortgage-backed securities, which are now complete, this portion of the statement is identical to the one after the last meeting.

Importantly, there is no mention of how these securities will eventually come off of the Fed’s balance sheet. Selling them would put upward pressure on mortgage rates, which is the last thing that the housing market needs now.

On the other hand, these are fairly long-term assets, so just waiting for them to roll off as people pay down their mortgages or refinance could take a very long time (more than 7 years, most likely). I would expect a combination of slow sales and run off, but not starting the sales until next year.

"In light of improved functioning of financial markets, the Federal Reserve has closed all but one of the special liquidity facilities that it created to support markets during the crisis. The only remaining such program, the Term Asset-Backed Securities Loan Facility, is scheduled to close on June 30 for loans backed by new-issue commercial mortgage-backed securities; it closed on March 31 for loans backed by all other types of collateral."

"In light of improved functioning of financial markets, the Federal Reserve has been closing the special liquidity facilities that it created to support markets during the crisis. The only remaining such program, the Term Asset-Backed Securities Loan Facility, is scheduled to close on June 30 for loans backed by new-issue commercial mortgage-backed securities and on March 31 for loans backed by all other types of collateral."

No change at all as the Fed tries to return to normalcy. Except in times of crisis, these sorts of loans are better made by the private sector markets than by the Fed. They were very useful during the crisis, but the need for them is gone.

"Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.

"Voting against the policy action was Thomas M. Hoenig, who believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to a build-up of future imbalances and increase risks to longer run macroeconomic and financial stability, while limiting the Committee’s flexibility to begin raising rates modestly."

"Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.

"Voting against the policy action was Thomas M. Hoenig, who believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to the buildup of financial imbalances and increase risks to longer-run macroeconomic and financial stability."

Tom Hoenig, the President of the Kansas City Fed, has been the lone dissenter for three meetings now. Given the huge amount of slack in the system, I think that Hoenig is not only wrong, but dangerously wrong.

The Fed should not even consider raising rates until capacity utilization, currently at 73.2% in total, gets much closer to its long-term average level of 80.6%. When it gets up to about 77% then it will be time to think about gradually raising rates. Similarly, we need to see the unemployment rate get down below 8% before starting a gradual (say 25 basis points per meeting) rise in rates.

Keeping short-term rates low should be good for the stock market, and is particularly helpful to the big banks like Bank of America (NYSE:BAC) and JPMorgan (NYSE:JPM). Their raw material is short-term money, which is effectively free right now. They can borrow at 0.25% or less, and then turn around and invest those funds in, say, a 5-year T-note at 2.50%, locking in an almost risk-free profit of 2.25%.

On big enough sums of money, this can be very profitable, and will help to recapitalize the banking system (provided they don’t drain capital by paying it out in dividends or frittering it away in outrageous bonuses to their top executives). Low interest rates will stimulate economic growth, which will help increase tax revenues and thus help (but not solve) the budget problems at all levels of government.

Not a lot of change from last meeting, but in this case, no change is good.