The Federal Reserve made only slight changes to the text of its statement, but those it did make signal slightly more optimism. It said labor market conditions show “further improvement,” rather than “some improvement” and sees “diminished” downside risks for the broader economy.
Normally, slightly more optimism on the economy should be taken as a “hawkish” sign for monetary policy. However, today’s statement was devoid of any hints of a tapering of quantitative easing. In addition, we now have a new “dovish” dissenter, St. Louis Fed Bank President James Bullard, who wants the Fed to focus more on its inflation goal given recent inflation readings below the long-term target of 2%. Meanwhile, Kansas City Fed Bank President Esther George continued to dissent against a policy she believes is overly accommodative.
In the press conference following the release of the statement, Chairman Bernanke provided some clarification of the current policy consensus at the Fed.
- First, the Fed views a 6.5% unemployment rate as a “threshold” for raising the federal funds rate, not an automatic trigger. So, for example, if the jobless rate drops to 6.5% and the Fed’s inflation projections remain below its long-term target of 2%, it will be slower to raise rates than if its inflation projections were running at or above 2%.
- Second, quantitative easing would end when the jobless rate falls to 7%.
- Third, there would be a “considerable” time lag between the end of quantitative easing and deciding to raise the federal funds rate. The use of the word “considerable” probably refers to a period somewhere from six to twelve months.
- Fourth, the Fed believes once it starts raising rates it will do so gradually, which probably means 25 basis points per meeting (2 percentage points per year), or less.
The Fed also made several notable changes to its economic forecast. It very slightly reduced real GDP growth this year, but added that growth into 2014. It made larger changes to its unemployment projections, cutting the rate for the end of this year to about 7.25% and cutting the rate at the end of next year to about 6.65%. The Fed also reduced its inflation projections for 2013-15.
Taking the Fed’s new economic projections at face value, it appears it now expects to end quantitative easing around May 2014 and start raising rates around April/May 2015. But we think these events will happen earlier. We project a 7% unemployment rate for December 2013, so an end to quantitative easing should be announced by the January meeting. Meanwhile, we are projecting a 6.5% unemployment rate in the third quarter of 2014.
One more item of note was that Bernanke said when the Fed gets around to selling off assets, it would not sell Mortgage-Backed Securities, implying it would only work with Treasury securities. In the end, we think the whole issue of selling assets will be less controversial and less interesting than many now fear. Once the Fed raises rates, it will automatically sell Treasury securities to banks and offset these sales by reducing banks’ excess reserves, which now total $1.9 trillion.
Either way, as we have written many times before, QE3 is simply adding to the already enormous excess reserves in the banking system, not dealing with the underlying causes of economic weakness, including growth in government, excessive regulation, and expectations of higher future tax rates. QE3 does not add anything to economic growth and, as long as banks are reluctant to lend aggressively, does not cause hyper-inflation either.
Nominal GDP – real GDP plus inflation – is already growing at around a 3.5% annual rate. At that pace, the economy can already sustain a much higher federal funds rate than now prevails. Maintaining rates near zero percent will eventually lead to inflation running consistently above the Fed’s 2% target, which means once it starts raising rates the peak will be higher than 4%, perhaps much higher.
This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy.
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