Following S&P’s decision to downgrade the sovereign credit rating for the US, Fed policymakers are unexpectedly faced with a meltdown in the stock market and worries about a double-dip recession. Since the stock market decline is not disrupting the banking system, the FOMC is likely to focus on economic conditions in formulating policy. Most FOMC members still expect a pickup in economic activity in coming months. With core inflation higher than a year ago and close to the Fed’s 2% target, we expect the FOMC to hold policy steady even as they acknowledge the need to monitor economic developments closely.
In the aftermath of QE2, which ended June 30th, policymakers at the FOMC were probably hoping for a quiet and uneventful meeting on 9 August as they assessed the lagged effects of the asset purchase program. Instead, they are faced with an unexpected plunge in the stock market and its potential disruptive effects on consumer confidence and spending. (The S&P500 index has fallen approximately 13% in the last five days, one of the steepest one-week declines on record.)
Though economic data has been generally disappointing for a few months, there have been a few encouraging signs over the past week or so. Private payroll job gains rebounded in July. The unemployment rate fell. Initial claims for unemployment benefits have been trending lower over the last month. Both car sales and chain store sales have picked up as well. With core inflation higher than a year ago when the FOMC was contemplating QE2, it certainly seemed that the policymakers would hold policy steady at this meeting. They would wait, anticipating that temporary factors that have held down the economy’s growth (such as supply disruptions in the auto industry) would gradually dissipate. At the same time they would hold on to the expectation that the lagged effects of their easy monetary policy would boost overall activity.
Until this past week, it is safe to say that no policy action was expected at this meeting. Now, however, with the stock market plunge, expectations have shifted and financial markets are again wondering about the possibility of a reaction by the FOMC to the sudden loss in wealth caused by the drop in stocks.
In our view, it is too soon to expect a response from the Fed. In his testimony to Congress in mid-July, Fed Chairman Bernanke indicated that it would take the re-emergence of deflationary risks to bring about “additional policy support” for the economy. Deflation could emerge as a risk if the economy were to fall into recession as a result of the plunge in equity values. But it is too soon to make that call. Stock markets can recover as quickly as they fall. The impact of financial losses on consumer spending is variable in both its duration and extent. It is not certain enough to drive a policy decision just now.
Nevertheless, it is worth considering what the FOMC might do if it did decide to respond to recent market turmoil. Here is a list of possible responses, in descending order of likelihood (by our assessment).
Change the description of economic conditions in the policy statement in the policy statement to acknowledge recent weakness in economic conditions and the possible stabilization of inflation. This would signal a shift if the balance of risks facing the Committee.
Alter the language about the “extended period” during which interest rates will be held at exceptionally low levels to signal a longer period than currently anticipated. While this is possible, it is not likely to have much of a market impact. Futures markets for fed funds have already pushed out the date of the first expected increased in the funds rate to the spring of 2013. It’s not likely that the FOMC would want to indicate an even longer “extended period” than that.
Introduce “extended period” language for how long the Fed will keep its portfolio of securities at its current level. There has been a lot of talk form the Fed about an “exit strategy” for reducing the size of the portfolio. Promising to keep the size of the portfolio constant for an extended period of time would remove that threat of a tighter policy. This would not likely have much effect, however, since few in the market believe the Fed is about to tighten policy by selling assets from its portfolio.
Introduce a “bias” to the outlook for policy. This was common in the past, but has been unused over the past few years. The FOMC could indicate that recent financial market developments has increased “uncertainty” about the economic outlook and that the Committee would monitor these developments and act as needed to foster price stability and economic growth.
Lengthen the “duration” or average maturity of the Fed’s portfolio of Treasury securities by targeting its re-investment of principal payments further out the yield curve. This could have the effect of putting some downward pressure on longer-term interest rates. While helpful, the effect would likely be minor since the volume of re-investment is small relative to size of the overall fixed-income market.
Embark on a new round of asset purchases (QE3). The QE2 program may have diminished the threat of deflation over the past year, but it did not seem to have that much of a lasting effect on economic growth. With core inflation higher now and close to the Fed’s 2.0% target, the payoff for a new round of quantitative easing may not be worth the risk of higher inflation that it might bring.
Lower the interest rate paid on bank reserves. With short-term interest rates at record low levels, there may not be much payoff for such a move. Lowering the rate paid to banks could also cause disruptions to the money markets as banks pay investors less for short-term deposits. Money market funds in particular might suffer even more outflows, reducing the credit intermediation that they currently perform.
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HSBC Global Research