For many years, every nuance of each utterance of anyone in a position of power within the Federal Reserve System (Fed) has been analyzed and dissected to try to anticipate the course of monetary policy.
Markets move and pundits pontificate based on perceived signals coming through the speeches, comments, press releases, and other information put forth. (Remember the stock market correction in response to the phrase “irrational exuberance” some years ago?)
In the press release following their meeting last week, the Federal Open Market Committee (FOMC), which sets and implements monetary policy, had some interesting things to say. While it’s impossible to tell exactly what was intended, there are nonetheless some hints at future directions. Because Fed policy affects interest rates, inflation, and the growth pace of the economy, it’s worth taking a look at this new information.
The key issue is the pace and method of “normalizing” monetary policy. At present, the Fed is taking an accommodative stance, keeping key interest rates (the federal funds rate) at virtually zero. The accommodation dates back to 2007, when the U.S. economy spiraled into a recession and quantitative easing (QE) began. The Fed’s QE was a program of bond buying aimed at injecting liquidity into the economy in response to rapidly worsening economic conditions.
As the Federal Reserve System purchased bonds, dollars were released into the financial system, helping push down interest rates in an effort to stimulate investment and consumption and, hence, help the economy recover. The process is, of course, more complicated, but that’s the essential idea.
The downsides of injecting money into the system are the potential for inflation and the knowledge that the liquidity will have to be withdrawn at some point down the road. The Fed officially ended QE last fall, but that was not the end of the accommodative monetary policy stance. At that time, inflation was not a problem and the recovery was not strong enough to risk backing off too far or too fast and sending the US backsliding toward a recession. Rather, the Fed began to pursue a slow course toward more normal conditions.
The Fed has said that it will normalize monetary policy by moving the federal funds rate higher. Key elements of the approach the Fed will be using have been made public and are spelled out in more detail in a Frequently Asked Questions (FAQ) section on the www.federalreserve.gov website (if you happen to be struggling with insomnia). When economic conditions warrant change in policy, the Fed has indicated that it will adjust the interest rates paid to depository institutions on excess reserve balances; as these trend higher, banks will have more incentive to hold balances rather than loan them out and will tend to charge higher rates to borrowers, thereby reducing liquidity. The FOMC also indicates that the Fed’s securities holdings will be reduced in a gradual manner, primarily by ceasing to reinvest principal repayments. Selling agency mortgage-backed securities is not currently part of the plans. All of these actions will slowly raise the cost of borrowing, which will tend to reduce consumer spending and business investment.
The question is one of timing. Comparing language in the press releases following FOMC meetings dated December 17 and January 28 reveals some changes in tone. Job gains were “solid” in December and “strong” in January. Economic expansion was “moderate” in December and “solid” in January. Inflation was below the Committee’s longer-term target in December and had “declined further” in January. These word changes hint that the Fed is seeing the economy as improving and strengthening, yet also viewing inflation as less likely in a falling oil price environment.
Even with this more favorable view of economic strength, the Committee reaffirmed its target of virtually zero for the federal funds rate. However, while the December press release and several before it say that target would likely be maintained for “a considerable time” (which typically means about nine months in Fed-speak), the January statement removes that language. There is also a new factor in the list of items the Fed will consider in deciding how long to keep that target range: international developments. This one is code for the Euro situation and basically provides more wiggle room (it is fairly rare for an item to be added).
All in all, the recent Fed-speak seems to indicate that a more positive outlook for the economy and job market are bringing us closer to more normal monetary policy. Even so, with inflation staying low, wages not yet rising, and Greece being unpredictable, the Fed is sticking with accommodative policy for the time being.
