A Middle-of-the Road Action from the Federal Open Market Committee

August 10, 2010

The Fed did not decide to expand its balance sheet, which isn’t surprising given the political brouhaha over its sharp rise during the severe recession.  A passive decrease in the central bank asset holdings as security holdings mature is likewise not being allowed.  A third decision to fortify the quality of the balance sheet was made, and this will occur because maturing mortgage-backed securities will be replaced with safer long-term Treasuries.  Bottom line here, policy is paused and will await further economic developments for future guidance.  The stance will not tighten in a de facto manner as the ECB is allowing, so if it is decided in the near future that more aggressive support is in fact needed, officials canl avoid the embarrassing confusion of aborting a process of balance sheet contraction and shifting to a second stage of quantitative easing, also known as QE2.

Tom Hoenig, President of the Kansas City Fed and a Ph.D. economist by training, dissented from the majority as he did at the March, April and June meetings.  He again objected to the reaffirmed conditional forecast that economic conditions “are likely to warrant exceptionally low levels of the federal funds rate for an extended period” and to today’s additional vote to not let the Fed’s longer-term security holdings diminish by attrition.  Hoenig alone among voting FOMC members dissented, as was the case at previous meetings.  His view of policy risks is not winning any converts.

Three notable downgrades in the Fed’s assessment of the economy were achieved by

  1. Adding the adjective “gradually” to the assertion that personal consumption is increasing.
  2. Deleting “significantly” from the prior statement’s assertion that “business spending on equipment and software has risen significantly.”
  3. Changing the forecast for the pace of economic recovery from “moderate for some time” to “more modest in the near term than had been anticipated.”

Today’s paragraph on inflation retains the same conclusion as before that such will be “subdued for some time” but underscores the undesirable downtrend in core inflation more emphatically.  In June when that observation first appeared, the statement merely read that “underlying inflation has trended lower,” whereas a time interval has now been added such that it reads, “measures of underlying inflation have trended lower in recent quarters.”

Interestingly, Fed officials continue to call unemployment “high” but remain conspicuously silent about the woefully low level of employment. The 29K deficiency of actual jobs at present from their 1980-99 growth trend-line is the most pressing threat to U.S. democracy at present, and the Fed is mandated to maximize employment, not minimize unemployment.  Bonds had a sharper reaction to the Fed’s statement than stocks.  The 2.76% yield on 10-year Treasuries is five basis points lower than at the time of the statement’s release, and the DJIA shaved only 39 points off its daily loss and closed still 55 points weaker on balance.  The dollar lost ground, too. 

The message one is left to absorb is that the U.S. economic recovery may be in the kind of funk in which Japan has languished for the past twenty years.  Unlike the aftermath of the last big U.S. recession and robust expansions this year in emerging Asia and Latin America, the U.S. business cycle isn’t conforming to the pattern that the harder it falls, the stronger it rebounds.  Over the 13 months following the 1981-2 U.S. recession, jobs advanced by 3.34 million workers, whereas employment last month was 398K lower than at mid-2009.  The table below compares real GDP growth (annualized) in the first four quarters of the 1980’s business recovery in the United States to growth in the four quarters since the recent recession.

  1Q83 to 4Q83 3Q09 to 2Q10
1st quarter 5.1% 1.6%
2nd quarter 9.3% 5.0%
3rd quarter 8.1% 3.7%
4th quarter 8.5% 2.4%

If the United States is unable to be an engine of world growth, conditions in China, India, and other developing economies become even more crucial.  China will be reporting several more indicators on Wednesday.  Tuesday’s offerings were softer than anticipated.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.



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