FOMC Leaves Stance Unchanged

The most notable change from June's statement was a more positive tone about recent economic and financial developments. The Committee's assessment however remained the same: despite recent improvement (described oddly as a "leveling out" of economic activity), weakness will continue for awhile and inflation will remain "subdued" due to considerable slack in the economy.

 

Otherwise, there were few surprises. Interest rates were left unchanged (continuing to target the federal funds rate range of 0 - ¼ percent),  and the Committee repeated its announcement that it would maintain the federal funds target rate at "exceptionally low levels" (still not defined) for an "extended period". The Fed also confirmed that it would continue support to the mortgage and housing markets through huge purchases of agency mortgage-backed securities and agency debt (basically, Fannie Mae and Freddie Mac securities and debt).

 

The only policy news in the announcement seems relatively minor - but you never know with the Fed. The Committee decided to slow the pace of its $300 billion Treasury securities purchase program so that the transactions are completed by the end of October (not September, which most observers had been expecting). The FOMC explained this decision as an attempt to promote a smooth transition in the markets as purchases come to an end. This decision is thought to indicate that the Fed is testing the waters, to observe financial market reactions to the announcement and to extend its purchases for another month before deciding whether to stop the program.  On the other hand, as the Fed stated, it could simply be a technical matter of an orderly transition.

 

Looking ahead, as the economy strengthens (many think we are in positive territory now), the focus will be on the Fed's unwinding of the massive resources it has put into the economy and financial system. In today's Financial Times, former Fed Governor Randall Kroszner warns about the importance of correctly timing the withdrawal of monetary stimulus and points to the Fed's "colossal mistake in its ‘exit strategy' in 1936-7, as the United States came out of the Great Depression. Similarly, CEA Chair Christina Romer, an expert on the Depression, has also warned about the "Lessons of 1937".  

 

Fiscal policy is also seen by many as part of the cautionary tale of the double dip recession of the 1930s. Perhaps implicitly warning that another round of stimulus could be counterproductive, Governor Kroszner noted that before the 1936 election, a temporary targeted "bonus" exceeding 1.5% of GDP was given to World War I veterans.  Fiscal stimulus was added to an economy already in recovery and growth was very strong as a result. The Fed responded - but it overreacted.   

As the Fed determines its exit strategy in the current situation, a key challenge, as Governor Kroszner points out, is to distinguish between growth resulting from short-term fiscal stimulus (alot of which will be spent in 2010 and 2011) and growth that has taken hold ("sustainable" growth), which comes with more inflationary risk.