The Federal Reserve's Monetary Policy Committee met today and, as expected, decided to leave the federal funds rate in the 0 to 1/4 percent range. Of more interest is the Committee's decisions on additional policies it might pursue such as initiating QE3, lowering the rate it pays on reserves, and altering its communications strategy.
Here is a list of the policies the Fed might have pursued, and what it actually decided:
1. A Change in Communications
The Fed has emphasized communications strategy as a policy tool, and it attempted to make use of this in its Press Release. For example, the Fed believes expectations are a key factor in the evolution of the economy, and by providing guidance on interest rate policy the Fed can affect expectations about the course of interest rates, prices, and other macroeconomic variables.
The Fed provided more guidance than I expected on interest rates, saying that:
The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013The Fed also provided some guidance on the balance sheet:
The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.I would have preferred more guidance here. When does the Fed expect it will begin to reduce its holding of more than 2 trillion in assets, more than triple the normal size? Importantly, however, this does leave the door open for adjustments in the balance sheet in either direction, so QE3 is not ruled out.
2. Lower the Interest Rate on Reserves
Some analysts have called for a reduction in the interest rate the Fed pays on reserves as a means of stimulating new loans and new investment.
As expected, however, there was no action here -- this isn't even mentioned in the Press Release. There are three reasons for this. First, Bernanke has stated in the past that this would be disruptive to the overnight federal funds rate market. Second, this is a key tool for freezing reserves in the banks and controlling inflation should inflation become a problem. Since it is harder to raise this rate than to lower it, the Fed is reluctant to lower it. Third, the supply of funds for investment is not the problem, it's the demand. Lowering the interest rate on reserves doesn't help to create more demand for loans.
Many observers, Joe Gagnon foremost among them, have called for QE3. However, except for the statement that the Fed is prepared to adjust the balance sheet "as appropriate," there is nothing specific on this in the Press Release. The economy has shown more weakness than the Fed predicted, but the main trigger for QE3 will be fear of deflation. There is some indication from bond markets that inflation expectations are falling, but they aren't as low as they were when QE2 was initiated and unless expectations fall further, QE3 is unlikely.
Overall, there weren't too many surprises. The federal funds rate will remain low, there was nothing specific in the Press release about QE3 but the door was left open for it, and the Fed acknowledged that the economy was weaker than it anticipated. As noted above, the one surprise for me was the specific guidance on the federal funds rate provided in the Press Release, and the dissension on the committee on this point is worth noting. Three members of the FOMC, Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, voted against the FOMC decisions. According to the Press Release, they did not like the guidance that the federal funds rate would likely remain "exceptionally low" through mid-2013. All three are relatively hawkish on inflation, Fisher and Plosser in particular, and they appear worried that this commits the Fed to a policy that could be highly inflationary. They would like more flexibility to respond to inflation as needed.
I believe the Fed should take a more aggressive stance than it has taken to date. Fiscal policy is off the table, if anything deficit reduction will work against the recovery, and the Fed needs to realize that at every turn it has underestimated the severity of the problem it faces. Again and again the Fed has pointed to green shoots as a reason to "wait and see" only to have them wither later on. This has left the Fed behind the curve. For once, I'd like to see the Fed get out in front of the problem, and with the recent emergent signs of weakness on so many fronts now would have been a great time for the Fed to show it can do more than look in the rear view mirror.