FOMC Continues Credit-based Policy of Quantitative Easing

• FOMC confirms that federal funds rate of 0 to 0.25% will be applicable for some time….
• .....downgrades economic outlook and sees inflation at lower level than warranted....
• ......will use all available tools to attain its objectifs...
• .....credit based quantitative easing preferred, but purchases of long-dated Treasuries as needed...
• .....Governor Lacker dislikes credit policy and favours traditional monetary policy tool: buying Treasuriesl

Rock bottom rates for longer...

The FOMC decided to keep its target range for the fed funds rate at 0 to 0.25%. It added that "economic conditions are likely to warrant exceptionally low levels of the federal funds for some time. By "promising" to keep these rates close to zero for a longer period, the FOMC clearly tries to keep longer dated rates low too.

Economic outlook downgraded, deflation a risk

The paragraph on the economy was considerable longer than after the December FOMC meeting. The economy has weakened further since December. Production, housing starts and employment have continued to decline steeply. Contrary to December, the significantly slowing of global demand was added. Positively, the FOMC stated that conditions in some markets had improved, but added that nevertheless credit conditions for households and firms remain extremely tight. The FOMC received the results of the Senior Loan Officer's survey at the meeting. It will soon be published for the public. Given the hint in the FOMC statement, the survey should indeed show very tight credit conditions, but maybe not tighter than in October.

On inflation, the wording of the statement is quite a bit changed, but without doubt the inflation outlook is downgraded and some deflation risk has appeared, without the FOMC using the D word though. The Committee expects that inflation pressures will remain subdued in coming quarters. "Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term."

FOMC promises to use all available tools

Like in December, the FOMC wants the public to know that they are aware of the severity of the situation and will do everything to help revive the economy and preserve price stability. The Committee clearly knows that a good communication to the public and the markets is important to influence behaviour in the desirable direction. "The Federal Reserve will employ all available tools to promote the resumption of sustainable growth and to preserve price stability."

Quantitative easing via credit policy re-affirmed

The Federal Reserve confirmed the use non-traditional policy tools. It continues the purchase of large quantities of Agency debt and mortgage-backed securities to provide support to the mortgage and housing markets. It will be implementing the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. So the quantitative policy of the Fed is explained in the December statement is fully confirmed. It is driven by its actions to help the restart or better functioning of credit markets, by making such credit cheaper and thus narrow the spreads above Treasuries applicable in these markets. Therefore, the policy works through the asset side of its Fed's balance sheet, while the more traditional quantitative policy works through the liability side of the balance sheet. The purpose is different, but the end result of more (or less) excess reserves in the system is the same. The Fed stands ready to expand the purchases or to extend their duration as needed.

No purchases of longer-dated Treasuries yet

In December, the Fed stated it was also evaluating the potential benefits of purchasing longer-term Treasuries Now the FOMC said it is also prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in prrivate credit markets. So the Fed came closer to such purchases, but didn't yet cross the Rubicon, which disappointed the market.

The Fed clearly favours the credit policy of buying certain assets in private credit markets above the more "traditional" policy of buying Treasuries to expand the excess bank reserves. In other words the narrowing of the credit spreads is favoured above the attempt to shift the risk free Treasury curve still lower. However, the Fed also knows that if the Treasury yields would increase substantially it would deteriorate conditions in private credit markets and "oblige" the Fed to start buying Treasuries. The big question is now where is the pain threshold of the Fed in terms of 10- and 30-year yields. Governor Lacker dislikes the credit policy of the Fed and voted for the more traditional approach of easing via the purchases of longer-dated Treasuries.

When Bernanke first suggested, at the end of November, that the Fed considered buying longer-term Treasuries, the long bond rallied and its yield dropped from about 3.25% to 2.5%. Inn mid December, the Fed disappointed the market by announcing some specific credit measures, but by adding only that it was evaluating the possibility to purchase Treasuries, the long end of the curve sold off pushing the 30-year yield back to 3.25%. In the run-up to today's meeting, renewed hopes on such a program of purchases of Treasuries pushed 30-year yields lower.

This was more than reversed when the FOMC statement was released, longer-date Treasuries sold off sharply, pushing the 30-year yield at some point 20 basis points higher, to close the session 16 basis points higher at 3.41%. It is obvious that the market, spooked by supply, is challenging the Fed. We suspect that the Fed that clearly left an opening to buy purchases won't let longer-term Treasury yields go much higher. It would work against the Fed objective of lowering mortgage and other rates.

The steepening and sell-off in the Treasury market was the most violent reaction following the statement. In other markets, the dollar gained against the euro and the yen, while equities ended a strong session at the highs, but without making additional substantial gains after the FOMC statement was released.

January 28 FOMC statement

The Federal Open Market Committee decided today to keep its target range for the federal funds rate at 0 to 1/4 percent. The Committee continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

Information received since the Committee met in December suggests that the economy has weakened further. Industrial production, housing starts, and employment have continued to decline steeply, as consumers and businesses have cut back spending. Furthermore, global demand appears to be slowing significantly. Conditions in some financial markets have improved, in part reflecting government efforts to provide liquidity and strengthen financial institutions; nevertheless, credit conditions for households and firms remain extremely tight. The Committee anticipates that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant.

In light of the declines in the prices of energy and other commodities in recent months and the prospects for considerable economic slack, the Committee expects that inflation pressures will remain subdued in coming quarters. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. The focus of the Committee's policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve's balance sheet at a high level.

The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longerterm Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets. The Federal Reserve will be implementing the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Committee will continue to monitor carefully the size and composition of the Federal Reserve's balance sheet in light of evolving financial market developments and to assess whether expansions of or modifications to lending facilities would serve to further support credit markets and economic activity and help to preserve price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Dennis P. Lockhart; Kevin M. Warsh; and Janet L. Yellen. Voting against was Jeffrey M. Lacker, who preferred to expand the monetary base at this time by purchasing U.S. Treasury securities rather than through targeted credit programs.

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