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Fed stands pat -- what next?

(MoneyWatch) The Fed announced today that there would be no change in its present policy.  It will continue to keep interest rates abnormally low until inflation expectations increase more than a half percent above target or the unemployment rate falls below 6.5 percent. The Federal Open Market Committee also said that it will continue its quantitative easing policy of purchasing $85 billion in financial assets per month.

The continuation of present policy was widely expected. However, since the unemployment rate is elevated and inflation is running below the Fed's two percent target, there was speculation before the two-day monetary policy meeting that the Fed might change its language to indicate a bias toward easing, or even announce an increase the pace of asset purchases. While the Fed didn't change the amount of purchases at this meeting, it did say that, "The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes." That statement, which leaves the door open in both directions, was not in the Press Release following its previous meeting.

What would it take for the Fed to do more? So long as unemployment keeps falling, even at a slow pace, the Fed is unlikely to increase the pace of its asset purchases. If unemployment spikes upward, that would likely spark action, but that's unlikely at this point. Thus, inflationary expectations, which have been falling recently, are the key to what the Fed is likely to do in the future. If the Fed expects inflation to continue falling as a result of a weak economy, and if it looks like actual inflation is falling as well, the Fed will likely take action. Of all the things that can happen, the Fed appears to fear disinflation/deflation the most. This has prompted action in the past and would very likely do so again.

Until the next meeting, the Fed is likely to try to use its communication strategy in an attempt to influence inflationary expectations. The Fed is very wary of doing more: it's in untested waters already and the risks are hard to quantify, and if it can change expectations with talk rather than action that would be best. In particular, there have been hints from members of the Fed recently that the end of quantitative easing may be near, and I expect the Fed will back off of this position. Thus, I will be closely monitoring Fed speeches over the next few weeks to see how concerned members of the Fed appear to be about falling inflation expectations, and how that translates into communication about when quantitative easing is likely to end.

The Fed is missing both of its targets -- unemployment is too high and inflation is too low -- and both of those facts call for further easing. But the Fed is hesitant to do more and it will avoid taking additional steps if it can. But if inflationary expectations continue to fall, and/or the fall in the unemployment rate stagnates, and if its communication strategy fails, it may have no choice.

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