Photo: Morgan Stanley
Here are the facts:
- The Fed is failing to meet both of its mandates. Unemployment is still well above where it should be (according to the Fed’s own forecasts) and inflation is trending below its goal of 2%.
- Bernanke says the Fed has more tools at its disposal that would help correct both of these shortfalls.
- Yet at Wednesday’s meeting, the Fed did the bare minimum, an extension of Operation Twist (buying long bonds and selling short bonds) that hardly anyone thinks will be a big needle-dialer. Even those at the Fed don’t seem particularly convinced.
So what explains the above? Why is the Fed not doing more despite missing on both of its goals and Bernanke saying there are more tools available.
According to Morgan Stanley’s Vincent Reinhart, deep rifts are being exposed.
Despite this dual shortfall, the Fed’s response is modest and incremental. It has extended its program to increase the average maturity of its holdings. They will “twist” some more, like they did last autumn, but only through year-end. Moreover, the Fed will only swim in the safest end of the fixed income waters—the Treasury market. They will purchase and sell about $267 billion of Treasury securities through year-end, buying at longer maturities and selling at shorter ones to keep the overall size of the balance sheet constant.
Bottom line, this was the path of least resistance—acting because market participants expected something but not acting much.
This suggests that the Fed is divided, doesn’t want to draw attention to itself right now, or doesn’t think that its remaining levers are very effective.
As for evidence of problematic group divisions, consider the forecast of the appropriate policy rate for the next few years. The range of views of policymakers as to where the funds rate will be at the end of 2014 spans from zero to 3 per cent. Line this up with the statement: Eleven FOMC members agreed to a statement that the funds rate would still be low by late 2014, but only six forecast an unchanged funds rate by then. That is, they do not agree on the definition of the word “low.”
A failure to agree on the definition of “low” makes it hard to imagine this Fed willingly doing a new round of aggressive easing, or really anything bold and unconventional.
And really, you don’t need to be a Fed Kremlinologist like Reinhart to see the divisions. Just this week, immediately after the Fed acted, the various Fed governors came public with their scepticism. Richmond Fed chief Jeffrey Lacker came out and said more twist wouldn’t work and that it risked spurring inflation (even though that would be one of its main goals).
And St. Louis Fed President Bullard actually came out and said that he thought QE3 would be “effective” but that it faced a high hurdle due to risks associated with the Fed balance sheet
So the Fed is all over the map. You have your inflation paranoids, those who think more easing would help (but still don’t want to do it) and those who can’t agree on the word low.
Between the splintering at the Fed (and also the ECB for that matter, although that’s a different story) and the softening economic data around the world, this has the combination of a worst-case scenario for investors and markets.