USA: Fed Pulls All the Plugs

Overview: The Fed went all the way yesterday night with the Federal Open Market Committee (FOMC) deciding to lower the fed funds rate from 1.00% to between 0% and 0.25%. The Fed's decision to target a range for the fed funds rate probably reflects difficulties experienced by the central bank in maintaining the actual rate close to its target at the same time as the monetary base is exploding. We expected such a move with economic data in recent weeks dreadful, inflation falling fast and the Fed having already shown its willingness to act aggressively. However, with markets only discounting a 12% probability of a cut to below 25bp the decision fuelled a rally in treasuries and further flattening of the curve while equities also rallied significantly.

The wording in the FOMC statement came as close as was possible to a commitment to maintain the fed funds rate close to zero for a long period, leaving no doubt that the Fed stands ready to adopt further quantitative easing. All eyes will now be directed towards the central bank's balance sheet with the fed funds rate having been defacto put out of the game for awhile.

Details: The Fed took another step in its efforts to reduce longer-term interest rates by stating that "the Committee anticipates that the weak economic conditions are likely to warrant exceptionally low rates of the fed funds rate for some time". The Fed's response continues to follow the script in Bernanke's famous "helicopter speech" from 2002. Although the fed funds rate has played out its role as the central bank's main policy instrument for now, the Fed has other instruments in its toolkit and will not hesitate to use them. The Fed retains an easing bias. According to the FOMC statement it "will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability".

The growth section of the statement highlighted labour market weakness and acknowledged that recent data signal a broad-based contraction in the domestic economy with declines in consumer spending, business investments and industrial production. Financial markets were described as strained and credit conditions tight. Without directly stating so, the inflation section indicated that the FOMC is not pleased by the rapid decline in inflation. The wording was similar to the previous statement in so far as it stated that "the Committee expects inflation to moderate further in coming quarters" but the phrase "to levels consistent with price stability" was left out.

However, most paragraphs in the statement are dedicated to explaining the conduct of monetary policy through quantitative easing. The new main policy instrument involves expansion of the Fed's balance sheet with other methods of doing so being considered (in addition to those already in place) including the purchase of longer-term Treasury securities.

Assessment & Outlook: With the Fed having finished its work on the fed funds target rate today, any further easing will be quantitative. Doubtless, the FOMC is deeply concerned by the economic outlook and takes the risk of deflation seriously.

With economic data likely to continue to remain weak in coming months and inflation heading down fast, we expect the Fed to take further measures in coming months unless a broad-based improvement in credit markets materialises. Such measures could include purchases of private sector credit instruments at any maturity, purchases of longer-term Treasury bonds and the further purchase of mortgage backed securities. We do not expect to see the Fed hike rates before the economy has returned to its trend growth and unemployment has peaked - probably a case for 2010.

Current 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.

Statement from the October meeting:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 1 percent.

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

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 in coming quarters to levels consistent with price stability.

Recent policy actions, including today's rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

Danske Bank
http://www.danskebank.com/danskeresearch

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