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The Fed Leaves the Target Rate and QEII Unchanged

The committee in charge of monetary policy, the FOMC, met today and decided to leave the target interest rate unchanged. The committee also decided to continue with its plans to implement QEII, a plan that attempts to stimulate the economy through the purchase of $75 billion in Treasury securities per month until a target level of $600 billion is attained. The continuation of present policy is not a surprise at all, committee members have been signaling in recent speeches that nothing would change, so the real question is when the Fed is likely to alter course.

As the Fed notes, presently the recovery is too weak to bring down unemployment, long-term inflation expectations are stable, and actual inflation is trending downward (it's presently below the Fed's target). So long as those conditions persist -- high unemployment, stable inflation expectations, and actual inflation below target -- the Fed will not change its policy.

How long will the conditions persist? Nothing will change until the Fed sees a couple of quarters of solid data showing that unemployment is falling and inflation is becoming a problem, so the policy is likely to stay in place for at least the next two Fed meetings. The first big decision point comes when QEII ends in the second quarter of 2011. At that point, the Fed will have to decide whether to extend the QEII program or end it as scheduled. My expectation is that the program will not be extended. QEII will only be extended (or increased in magnitude) if the economy double dips or if deflation risks have not diminished, something that could happen, but seems unlikely at this point. However, although the Fed will likely allow QEII to end, the Fed is unlikely to begin increasing the target interest rate at the same time. The fear is that the combination of the end of QEII and an increase in the federal funds rate would be too much tightening too soon and threaten to undermine the recovery.

Thus, while I expect QEII to end on schedule, I don't expect much to happen to interest rates until the end of 2011 at the earliest, and it may be even longer than that. A sudden decline in unemployment, or a sudden increase in either inflationary expectations or actual inflation could alter that, but since the expectation of most analysts is for a very slow recovery, a view I share, I see that as unlikely.

Here's the text of the announcement:

Press Release, Release Date: December 14, 2010, For immediate release: Information received since the Federal Open Market Committee met in November confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment. Household spending is increasing at a moderate pace, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. The housing sector continues to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have continued to trend downward.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.
To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Sarah Bloom Raskin; Eric S. Rosengren; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.
Voting against the policy was Thomas M. Hoenig. In light of the improving economy, Mr. Hoenig was concerned that a continued high level of monetary accommodation would increase the risks of future economic and financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy.
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