The Fed: Still Inching Toward a Policy Exit

The Federal Reserve, compressing its typical two-day policy session into a single day, edged cautiously further along the continuum between aggressively stimulative and less generous monetary policy on Mar. 16. While the federal funds rate target was held to its 0%-to-0.25% range, the language in the statement released after the meeting continued to evolve in terms of how the recovery is taking hold—and the extent to which inflation risks remain contained.

Even as the leadership of the policy-setting Federal Open Market Committee has tilted toward the doves, the inflation hawks have become increasingly vocal. Kansas City Federal Reserve Bank President Thomas Hoenig voted against the Fed's policy decision, as he did at the Jan. 27 FOMC meeting. Hoenig was more expansive in his dissent in the statement this time around, though he was not joined by any of the other leading hawks, such as St. Louis Fed President James Bullard.

Previously, Hoenig "believed that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted." This time around he "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." Look for this tug-of-war between the doves and hawks to be a central theme to the policy process heading into the spring-summer period.

Bullish on Business Spending

The FOMC also reiterated its intention to wind down its programs to purchase mortgage-backed securities and agency debt at the end of the month, though with the usual caveat that the programs could be resurrected in light of any new systemic stress. 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 Mar. 31 for loans backed by all other types of collateral.

The Fed made a number of tweaks to the economic overview behind its decision. The first was that the labor market was "stabilizing" as opposed to the previous "deterioration abating" statement. It was more bullish on business spending on equipment and software, which "has risen significantly," in contrast to "appears to be picking up." The statement also specified that "investment in nonresidential structures is declining, housing starts have been flat at a depressed level," which was more specific and pessimistic vs. "investment in structures is still contracting."

As for inflation, the Fed made no change to its view that "with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time."

The Hawks May Squawk

Treasury yields dipped lower on the FOMC headlines on Mar. 16, though the Fed essentially stuck to its script. The two-year yield held below 1%, dropping back down to 0.9% from 0.96% at the start of trading. The 10-year yield slumped from 3.71% to 3.65%. Stocks advanced, with the large-cap Standard & Poor's 500-stock index posting a gain of 0.78% on Mar. 16.

The Fed maintained an exceptionally cautious accommodative policy stance, opting to retain the view that its position will remain in place for an extended period. While the Fed noted pockets of improvement in business spending and the return of some stability to the labor market, the overall tone was not one of overconfidence. Fed policymakers will want more evidence that the recovery is self-sustaining before they take more aggressive action. That lays the foundation for more protest from the hawks if the markets and data prove stronger than expected.

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