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The Fed to the Rescue?

Contributed by Raymond James

Citing concerns about the pace of improvement in the labor market, the Federal Open Market Committee extended and amplified its forward guidance and started a third round of large-scale asset purchases (what most people call “QE3”). The FOMC said that economic conditions are expected to warrant exceptionally low levels of the federal funds rate target through mid-2015 (vs. “late 2014” in the previous policy statement) and added that “a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” The Fed’s latest bond-buying program will be in mortgage-backed securities and, unlike the first two asset purchase programs, is open-ended ($40 billion per month, with no specified end date). In his press briefing after the FOMC meeting, Chairman Bernanke emphasized that the Fed wanted to see “substantial” improvement in the labor market, but declined to assign specific numbers to that. Bernanke also said that the Fed cannot do everything (including offsetting the negative impact of the fiscal cliff, should that occur), but it obliged to do what it can to support economic growth in the context of price stability.

In his press briefing, Bernanke began by noting that the labor market outlook was “still a grave concern.” Economic growth has been moderate, he said, “but not fast enough to make significant progress in reducing the unemployment rate.” The Fed is not out of ammo. Bernanke said that “if we do not see substantial improvement in the outlook for the labor market, we will continue the MBS purchases, undertake additional asset purchases, and employ our policy tools as appropriate until we do.” He did not provide specific guidelines, but said “we will be looking for the sort of broad-based growth in jobs and economic activity that generally signal sustained improvement in labor market conditions and declining unemployment.” The conditional policy outlook is meant to reinforce consumer and business expectations of future policy, but the lack of specificity is likely to be a negative for the markets in the near term.

A number of economists have called for the Fed to push inflation above the 2% target to spur the recovery. Does QE3 and the amped-up forward guidance language indicate that the Fed will trade off higher inflation for lower unemployment? Not at all. The Fed remains committed to its 2% target for the PCE Price Index. Still, many market participants believe that the Fed is continuing to sow the seeds of substantially higher inflation down the line. Despite some pressure from higher food and energy prices in the short-term, inflation expectations remain well-anchored. In addition, measures of core consumer price inflation have been trending lower. Excluding fuels, import prices are trending down. Outside of food and energy, pipeline inflation pressures have generally moderated. Given huge slack in the job market, labor costs remain muted.

Critics have charged that we’ve had QE1, QE2, and Operation Twist, yet the economic recovery has remained disappointing. Bernanke countered that we still face a number of headwinds. The Fed cannot do everything. Fiscal policy, rather than helping, is set to remain a significant headwind for the economy. However, the Fed has to do what it can to support growth.