Fed decision: There were two surprises (Mellon)

“As expected, the Federal Open Market Committee (FOMC) kept policy on hold at its extremely accommodative stance and kept its messaging on track at its most recent meeting.” Vincent Reinhart Chief Economist and Macro Strategist at Mellon, comments on the Fed’s interest rate decision.

The reason it was no surprise is because it is central to policy design. The Federal Reserve (Fed) sets its policy on a forward-looking basis. Set the stance (read largely to include the level of the funds rate, size and composition of the balance sheet, and lending and purchasing facilities) based on the economic outlook. If the outlook unfolds about as expected, there is no reason to change the stance of policy. In Powell’s terms at his press conference, the economy is not in a good place, but it is in the expected one. As a consequence, “policy is in a good place.”

Three other messages ran to form. First, Powell repeated the limits of monetary policy, in that the Fed’s facilities rest on “lending not spending powers,” in a plea for additional fiscal impetus. Second, Fed officials apparently have no immediate appetite for formal interest-rate guidance or outright yield-curve control, although they apparently were presented with staff material on the topics. Third, features of the facilities remain in play, consistent with the expansion of the perimeter of the Fed’s protection over time as witnessed by tinkering with two of them in the past week. Powell suggested that the next direction they head with the facilities is toward helping non-profit organizations.

There were two surprises

First, despite Powell’s earlier forceful characterization that the recession will cast a long shadow on real economic growth, the FOMC did not move its longer-run assessments of real GDP growth, the unemployment rate, and the equilibrium real fed funds rate. His rationale was that it is “…way too early” to make such adjustments, and he hoped that well-designed policy could avoid much of those ill effects. Some of this might be about monetary policy, in that the distribution of the appropriate funds rate shifted inward, even as the median was unchanged.

Second, the FOMC rolled out the “dot” plot (to my chagrin), a form of rate guidance, even though Vice Chair Clairda asserted earlier that rate guidance might have to wait until September and despite its messaging drawbacks. The “dot” plot sometimes muddles the FOMC’s message when it draws attention to the outliers in the group who expect substantial and sooner firming than the rest of the pack. The answer is that Powell’s committee holds a remarkable uniformity of views. All participants expect to keep policy on hold through the end of next year and all but two through 2013.

What to look forward to?

Nothing on the monetary policy front if events rolls along the direction of the Fed’s forecast, which includes a gloomy 6-1/2 percent decline in real GDP this year. Given quarterly arithmetic, the economy does not dig out of its current hole until 2022. Maximum employment and inflation at goal seem out of reach for the next 2-1/2 years, The Powell’s board of governors will not sit on their hands regarding the exercise of the Federal Reserve Act 13(3) lending powers. They have tweaked the existing facilities at a pace of about once per week since implemented, mostly expanding their scope and lengthening their duration. Powell apparently sees problems at non-profits (hospitals, universities, and colleges?) and could create a window for them.

Monetary theorists, with a few governors and many Reserve Bank presidents counted among that tribe, prefer to work with closed models describing behavior across all possibilities. Nothing does that better than a rule about the policy rate. Thus, there is a strong pull toward closure among many FOMC participants so expect them to pump in public for some rule. Yield-curve control is a topic for further conversation, but probably not more than that unless pressed by markets.”

Categorised in: Monetair, Research