By: Costas Bocelli — September 23, 2010
To Inflate is Great: Fed Wants You to Pay More for Food, Etc
ALL EYES WERE ON THE FOMC POLICY ANNOUNCEMENT MID AFTERNOON TUESDAY. PEOPLE WANTED TO SEE WHAT THE FED HAD UP THEIR SLEEVE TO REGAIN THE MOMENTUM OF THIS FLEDGLING ECONOMIC RECOVERY.
With unemployment continuing to stay stubbornly high, bank credit contracting, and housing data remaining weak, there is growing anticipation of a fresh round of quantitative easing since the Fed opened the possibility in their last meeting in August.
In its August meeting, the Fed made a highly contentious decision to purchase additional US Treasuries to maintain its balance sheet at $2.054 Trillion to offset the reduction in its mortgage backed securities portfolio from the recent wave in homeowner refinancing that retired the balances at a rapid pace. The idea was to keep liquidity constant in the market place by the replacement purchases to prevent unintended tightening.
They also opened the door to additional purchases if economic conditions deteriorated. The decision, which was approved 9-1 by the voting members, was not collectively endorsed as the voting portrayed.
When the Fed minutes were released three weeks later, over 30% of the committee members expressed concerns regarding this strategy. Officially, the Kansas City Fed President Thomas Hoenig dissented on the interest rate policy and purchasing additional US Treasuries maintain the size of the balance sheet.
Other “unofficial dissenters” include Dallas Fed President Richard Fisher, Minneapolis Fed President Narayana Kocherlakota, and Richmond Fed President Jeffrey Lacker.
Much of their concerns are in regards to the difficulty of unwinding the easing programs when the time comes, and the insignificant effect it would have on the key issue: reducing the unemployment rate.
The dissent and debate is so prevailing among the members that they began the Tuesday meeting earlier than usual to ensure ample time to address all the concerns prior to the 2:15 p.m. announcement.
The Fed minutes from this meeting will be released on October 12, and it will surely be telling to gauge the magnitude of the division this time around.
THE FOMC POLICY ANNOUNCEMENT
As anticipated, there was no change in the fed funds rate or the language as they maintained the “extended period of time” statement in regards to any changes in interest rate policy.
They are also maintaining the $2.054 Trillion dollar balance sheet benchmark by continuing to purchase US Treasuries.
They announced no further asset purchases above this level at this time. However, key language changes from the August policy statement suggest that they are closer to triggering additional quantitative easing, and this moved several key markets shortly after the announcement with substantial follow through into Wednesday’s action.
One major language change was directly related to an increasing concern with inflation levels. The committee has now acknowledged that inflation is too low and it’s missing the target levels. This is one of the biggest worries for the Fed.
The other major language change was in regards to when and why another round of quantitative easing would need to be implemented. The previous language used that would prompt activation of additional measures was if economic data “continues to deteriorate”. The new language used now omits "deterioration" and replaces the use of "easing" with simply “supporting the recovery”.
With the Fed clearly worried about disinflation -- or flat out deflation -- they're essentially saying that if the economic data not only deteriorate but levels off, then they are ready to ease.
These key language changes clearly signal that the Fed may be on the verge of more quantitative easing.
THE EFFECTS OF THE FOMC STATEMENT
Well, the equity markets were expecting some additional easing sooner than later, and caught a bit of a hangover from the September rally.
Equities in Europe sold off roughly 1% when the markets opened on Wednesday, and US Equities were weaker to end Tuesday’s session. The selling was a little more prevalent on Wednesday, with the S&P 500 closing at 1134. A slip below 1131 or the 200 day moving average of 1116 might trap the market back into its 5 month trading range.
Currencies, commodities, and interest rates moved swiftly on the indications that the Fed will ramp up the printing presses. The US Dollar Index plummeted below 80, a key support level. Global currencies rallied, and precious metals such as Gold and Silver made new highs as the easing devalues the US Dollar. Bond prices rallied, sending yields on the long bonds down sharply, with the 10 year note approaching 2.50% and the 30 year note below 3.80%.
WHEN WILL THE FED EASE?
If the Fed does initiate Quantitative Easing Part II, it will most likely come after the Mid Term Elections on November 2. The Fed has their next meeting on Nov 2-3, so it could happen then or perhaps when they meet for the last time on December 14.
The Fed tends to not make any significant policy announcements going into any major political events such as elections, as they are supposed to be a neutral, nonpartisan entity. Any such policy announcement could possibly affect political outcomes, which they try to avoid.
Also, with the September stock market rally, it gives the Fed some breathing room as the markets are not in panic mode. That could change between now and the elections, but as long as the markets remain orderly, the Fed can wait it out until after the elections and get a few more economic data points.
Clues to look for between now and election time to determine if the Fed is likely to pull the trigger:
2. No significant improvement in existing and new home sales
3. Low inflation numbers in PPI and CPI
4. A Poor Non Farm payrolls report on Oct 1
5. Fed downgrade on GDP growth