Federal Reserve's Key Rate-Setting Committee Extending Massive Bond Buying As US Economic Growth Appears Somewhat Less Robust Than Earlier Throught

  @MikeObelm.obel@ibtimes.com on July 31 2013 2:10 PM
Federal Reserve building pedestrians
A view of the U.S. Federal Reserve building in Washington, D.C. Reuters

The key rate-setting committee of the Federal Reserve said Wednesday it is keeping the federal funds rate steady at zero to 0.25 percent and continuing its extraordinary bond purchases, two measures that aim to help the economy recover from the 2008 recession. But it also signaled fresh concerns about the strength of the economy and, by implication, a possible delay in "tapering."

The business and investment communities had expected the U.S. central bank’s key Federal Open Market Committee (FOMC), which on Wednesday concluded a regularly scheduled two-day meeting, to keep the federal funds rate steady and extend its extraordinary monthly purchases of $85 billion in bonds, also known as quantitative easing (QE). This is the Fed’s strategy for pushing down long-term interest rates to near zero and thus helping the economy recover from the 2008 recession.

But what was somewhat surprising was the slightly less sanguine characterization of the economy. Specifically, the Fed pointed to three developments that bear watching: low inflation; higher mortgage rates, which could kill the resurgent real estate market; and what the bank called "modest growth," a term used by the bank to denote something less than "moderate growth," which is the phrase it has been using to describe the nation's economy.

"Information received since the Federal Open Market Committee met in June suggests that economic activity expanded at a modest pace during the first half of the year. Labor market conditions have shown further improvement in recent months, on balance, but the unemployment rate remains elevated," the FOMC statement said. "Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen somewhat and fiscal policy is restraining economic growth. Partly reflecting transitory influences, inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable."

The FOMC voted 11-1 for keeping the federal funds rate steady and extending the money printing. The lone dissenter was Esther L. George, "who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations," the FOMC said in a statement. The Fed’s QE has swollen its portfolio to $3.53 trillion -- a fourfold increase since before the 2008 financial crisis. Eventually, the Fed will need to gradually sell its portfolio. 

The possibility that the U.S. central bank is less confident that the economy can stand on its own without monetary assistance could delay the onset of tapering, which has been expected to start in this fall or winter.

Since Bernanke first dropped hints in mid-May that QE tapering might occur later this year, the yield on the 10-year Treasury note has jumped from roughly 1.9 percent to 2.7 percent.

“The debate within the Federal Open Market Committee over whether or not to start tapering the QE program is probably over," said HSBC's Chief U.S. Economist Kevin Logan. "The question now is how to sufficiently prepare markets for the event and to decide when to actually start tapering.”

The most recent economic data signals steady if slow growth. The Commerce Department’s first estimate of the nation’s gross domestic product (GDP) in the second quarter, issued Wednesday, came in at 1.7 percent, up from the first quarter’s downwardly revised 1.1 percent. Analysts had expected the second-quarter GDP to be in a range of 0.9 percent to 1 percent.

Further, private employers in July added an unexpectedly robust 200,000 jobs in July, more than the 180,000 Wall Street had anticipated. The Automatic Data Processing report, which also came out Wednesday, showed broad-based job creation.

Other measures of employment are also positive. Thomas Costerg, an economist at Standard Chartered PLC in New York, said before the FOMC meeting that nonfarm payroll gains averaged 196,000 per month in the second quarter, broadly in line with the historical one-year average.

The housing market has also been a key driver of underlying growth; new home sales in June rose to their highest level since May 2008. The wealth effect from stock-market gains and rising home prices has also cushioned the fiscal consolidation somewhat. Interest rates remain low with the Fed’s accommodative policy, although long-term rates have risen over the past few weeks.

A recent Bloomberg poll reported that half of 54 economists surveyed expected the Fed to start tapering in September. Bank of America Merrill Lynch’s interest rates strategy team said the markets have been pricing in a 75 percent chance of September tapering, while the bank continues to hear from investors who think September is a “done deal.”

“The probabilities of the Fed slowing the pace of QE3 purchases sometime between September and the end of the year look to us to be roughly evenly distributed,” Michael Hanson, U.S. economist at Bank of America Merrill Lynch, said before the latest FOMC meeting. But with growth and inflation running notably below the Fed’s projections for this year, Hanson said he believes the Fed won't start tapering until December.

The problem for the FOMC is that in September it will have to review its forecasts, which are too optimistic on both growth and inflation, Hanson said before the FOMC meeting. It will be very difficult for the FOMC to simultaneously lower their forecasts yet announce the start of tapering.

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