FOMC Officially Announces Policy of Quantitative Easing
- United FOMC takes bold action, sets target range for federal funds rate of 0 to 0.25%....
- .....and lays down the principles of its quantitative easing policy, without calling it as such ....
- .....The Fed started the biggest US monetary policy experiment ever....
- .....in an attempt to stabilize financial markets and save the economy from a severe recession...
- .....Markets understand the historical dimension of the decision and react sharply
End of rate cut cycle...
The FOMC decided to set a target range for the fed funds rate of 0 to 0.25%, effectively ending its rate cut cycle. At the same time, the board decided to lower the discount rate by 75 basis points to 0.25% and established interest rates on required and excess reserve balances of 0.25%.
The Fed's interest rate cut exceeded the market expectation for a 50 basis points decline to 0.50%, but is symbolic as the effective fed fund rate traded already near 0.10-0.15% recently. By officially cutting to 0-0.25%, the Fed clearly wanted to signal that it no longer will target the price of money, the usual intermediate objective of policy, but instead starts with targetting the quantity of money available in the system, the so-called quantitative policy. If it had kept rates at 0.50%, there might still have been confusion about its policy in Wall Street and in main street.
Economic outlook grim, inflation off radar
In a sober language, the Fed stated that labour market conditions had worsened, while consumer spending, business investment and industrial production had declined. Financial markets remained quite strained and credit conditions tight. It concluded that the outlook for economic activity had weakened further. So, downside risks to growth prevail.
On inflation, the statement is understandably short. Inflationary pressures have diminished appreciably and the Committee expects a further moderation over the coming quarters. So, inflation is off the radar. There was no hint whatsoever about the possibility of deflation. The November CPI data, published yesterday, confirm the absence of inflationary pressures, but suggest deflation may become a concern soon.
Principles of its quantitative easing policy
The Committee said the Fed will employ all available tools to promote the resumption of sustainable growth and to preserve price stability.
Very importantly, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. So, market participants are encouraged to adapt their attitude knowing that rates won't be raised anytime soon (probably not without warning in advance either). The predictability of policy is an important item for a succesful implementation of such a policy of quantitative easing. Interestingly, no exact period of time was specified to give the Fed some leeway in the future, but it is safe to presume that the zero rate will stay in place for at least one year.
How will the Fed proceed?
In a rather long paragraph, the FOMC explains which measures will be taken, mostly measures that have already been announced.
The focus will be to support the functioning of financial markets and stimulate the economy through a number of open market operations and other means that sustain the size of the Federal Reserve's balance sheet at a high level.
The Fed will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets (announced already some weeks ago). It might expand these purchases as conditions warrant. Mortgage rates fell sharply when the Fed announced its plan to buy $500B Agency MBS and $100 B Agency debt some weeks ago. The statement now speaks of MBS in general, meaning that potentially also subprime, Alt-A and other non-conforming MBS might be bought.
The FOMC is also evaluating the potential benefits of purchasing longer-term Treasuries, a measure Bernanke already suggested some time ago. However, no details are released about maturities that will be targetted nor about eventual yield levels the Fed aims to install with its purchases. Long term yields have dropped to new historical lows since the prospect of quantitative easing increased. This might have been the reason why the Fed didn't find it necessary to specify its policy in the statement and to implement it. The Fed might be satisfied at this moment with these yields and concentrate on bringing other market rates like mortgages, CP and consumer loan rates down.
Early next year, the Term Asset-Backed Securities Loan Facility (TALF) will be implemented. The objective is to facilitate the extension of credit to households and small business.
Finally, the Fed will continue to consider ways of using its balance sheet to further support credit markets and economic activity. So the Fed wants to keep all options open for action on other markets, like for instance the corporate bond market.
Market reacts exuberant
Equities were already higher before the FOMC decision was made public, but the Fed taking even more decisive action than expected triggered a vigourous rally leaving the S&P more than 5% up on the day. US Treasuries embraced the official start of quantitative easing by rallying sharply and flattening the curve in a major way. The March Note future rose more than 2 and the long bond future even more than 3 full points. In yield terms, all maturities set new historical lows. The 2 year yield dropped 8.9 basis points to 0.65%, the 5-, 10- and 30-year yield shed between 17 and 25 basis points settling at respectively 1.30%, 2.26% and 2.78%. The dollar paid the “logical price and EUR/USD surged to 1.41 and USD/JPY fell below 90.
December 16 FOMC statement
The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.
Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further.
Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.
The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.
The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will 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 its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.
In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco. The Board also established interest rates on required and excess reserve balances of 1/4 percent.
Disclaimer: This non-exhaustive information is based on short-term forecasts for expected developments on the financial markets. KBC Bank cannot guarantee that these forecasts will materialize and cannot be held liable in any way for direct or consequential loss arising from any use of this document or its content. The document is not intended as personalized investment advice and does not constitute a recommendation to buy, sell or hold investments described herein. Although information has been obtained from and is based upon sources KBC believes to be reliable, KBC does not guarantee the accuracy of this information, which may be incomplete or condensed. All opinions and estimates constitute a KBC judgment as of the data of the report and are subject to change without notice.
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