The Fed's Cautious OptimismMichael Wallace
The Federal Reserve played a cool policy hand at its Apr. 28-29 meeting, holding rates steady near their historic lows and sticking to the limits set for its quantitative easing program adopted in March. Yet the Fed largely followed the blueprint provided by the Beige Book report earlier in the month, which described an economy that remained weak, with downward price pressures, but with a pace of decline that appeared to be moderating.
As to the Aug. 29 post-meeting statement, the Fed reiterated that the economy continued to contract as the recession spread from the financial sector to consumption, and then to the business sector, as detailed in the advance reading of the first-quarter gross domestic product report. Since the previous meeting, equity prices, as measured by the S&P 500-stock index, have erased their 2009 losses and recovered some 25% from the March lows of 667 to crack 875. The credit and financial markets appear to be mending, but the Fed is still aiming to give them more time to heal.
On the economy, the Fed was more optimistic: "The economy has continued to contract, though the pace of contraction appears to be somewhat slower. Household spending has shown signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit." The Fed noted that weak sales prospects and tight credit conditions have led businesses to cut back on inventories, fixed investment, and staffing. And although the economic outlook has improved modestly since the March meeting, the Fed said that "economic activity is likely to remain weak for a time." Taken together, these statements represent an upgrade to the Fed's pessimistic growth outlook, though the claims are still heavily qualified by the stated risks to that view.
As to inflation, policymakers remained concerned about deflation risks: "In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term."
The Fed remains hopeful about its diagnosis and expects its remedies will work over time: "Nonetheless, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability." This was in line with the view espoused in March.
30-year yield surges
Yet as insurance against these deflation risks, the Fed said it would employ "all available tools to promote economic recovery and to preserve price stability." The FOMC stuck to its target range for the federal funds rate at 0% to 0.25%, and signaled that rates are likely to remain at exceptionally low levels "for an extended period." This reference stopped short of giving a timeline of 18 to 24 months for the current policy, as anticipated by some market participants.
The Fed also recapped its quantitative easing plans so far: purchase of a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year, and the purchase of up to $300 billion of Treasury securities by autumn. The central bank reiterated its intention to facilitate the extension of credit to households and businesses and support the functioning of financial markets through a range of liquidity programs. Although it held fast on additional moves, the Fed hasn't ruled out additional steps or unwinding of previous measures.
Prior to the meeting, there had been persistent speculation that the Fed might ramp up its Treasury purchases after the Treasury-note yield moved back above 3.0%, underscored by PIMCO bond fund manager Bill Gross's warning that the 3.00%-3.10% zone could be the "line in the sand" for the Fed, while other sources have suggested that the 3.15%-3.25% area could trigger more intense quantitative easing. Such action was not signaled on Apr. 29. Yet, thanks partly to Fed purchases of agency and mortgage-backed securities debt, mortgage rates have remained near record lows, and the Fed is unlikely to give the market such an easy target.
After the Fed's Apr. 29 announcement, Treasury yields broke out to the upper end of their 2009 ranges. The 10-year yield, which had bottomed near 2.08% in December, snapped back above 3.10% on Apr. 29. The 30-year yield surged from 2.53% lows in December en route to a high of 4.07%. Stocks managed to sustain some optimism about the Fed's steady hand, with major indexes finishing the day with gains of more than 2%. The U.S. dollar index plunged more than 1.2% ,to lows of 84.17, before trimming losses near the close of trading.
Following the dramatic moves in March, it was incumbent on the Fed to shift back to a more steady approach, as the pace of the economic decline appeared to moderate following one of the most challenging episodes in its history. The danger that the Fed will overdo its quantitative easing is equal to the risk that it will reverse current policy too quickly, as evidenced by the heated debate on the topic and the steeply rising unemployment rate.
For now, the Fed will have to bide its time until more data accumulates showing that its policies have had their desired effect, while hopefully keeping its credibility intact—and its balance sheet in control.