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Fed Policy Outlook – Changes On The Way?

Contributed by Raymond James

By Scott J Brown

The Federal Open Market Committee will meet on Tuesday to set monetary policy. The Fed is widely expected to leave short-term interest rates unchanged and the wording of the economic assessment should be largely the same as in the previous statement. However, we could see another round of asset purchases or some changes to the Fed’s communications.

The inflation outlook is moderate. It doesn’t look like we’ll see substantially higher inflation in 2012, but (barring a large negative shock to growth) we’re unlikely to see a threat of deflation. That suggests little scope for a further round of asset purchases. However, Fed officials have been very disappointed by the housing market, which has struggled to get up off the mat. Home prices have stayed soft and it’s estimated that 22% of mortgage holders remain underwater. Fed purchases of mortgage-backed securities would not turn the housing sector around overnight, but it should help at the margins. In the last few months, a number of senior Fed officials have discussed the potential for MBS purchases, but it doesn’t look like there’s a strong enough case to pull the trigger on that just yet.

Some Fed officials have been uncomfortable with the Fed’s commitment to keep short-term interest rates low. Recall that in August, the FOMC shifted that commitment from “an extended period” to “at least through mid-2013.” This commitment has always been conditional on “low rates of resource utilization and a subdued outlook for inflation over the medium run,” but some Fed officials want to formalize that, tying low rates to specific measures of inflation and unemployment. Unfortunately, there are problems with using specific economic variables. In practice, these are statistics, and are subject to measurement uncertainty, seasonal adjustment issues, noise, and so on. The drop in the unemployment rate over the last year is a good example (the rate fell from 9.8% in November 2010 to 8.6% in November 2011, suggesting significant improvement, but the employment population ratio rose only slightly over this period). Hardwiring policy decisions to the data generates some risks, which is one reason that the Fed has been reluctant to adopt an official inflation target. Indeed, the Fed has typically used the PCE Price Index ex-food & energy as its chief inflation gauge, but there are other measures of core inflation, and they can vary a lot over time.

Policy rules can be made flexible (and in practice would be made so), but the financial markets and other observers may not always appreciate that flexibility. Markets could overreact to minor movements in the data, adding to overall volatility. Communications are important to the Fed, but at this point one should expect a lot more internal debate before any conclusions are reached. As already stated, the Fed has spelled out the conditions for keeping rates at very low levels.

Europe: Leaders came up with a fiscal compact, although the United Kingdom opted out, possibly setting up future conflicts between the European Union and the euro zone countries embedded in it (each group with different, perhaps conflicting, rules). The agreement, which is expected to be approved within a few months, buys the euro zone some time, but it does not get to the root of the crisis and is not a solution.

As expected, the European Central Bank lowered short-term interest rates and made efforts to improve liquidity. However, ECB President Draghi indicated that the ECB would not play a major role in propping up troubled sovereign debt. The markets had overreacted to Draghi’s comments of the previous week (which were misinterpreted to mean that a fiscal compact would lead the ECB to do a lot more). Eventually, the ECB is likely to take a larger role, but only after all other alternatives are exhausted. Hopefully, it won’t be too late.