Fed's Monetary Policy Committee Sees Improvement; Policies Stay Unchanged

Following its two day meeting yesterday and today, the Fed’s monetary policy setting body (the Federal Open Market Committee or FOMC) released its concluding statement this afternoon.

The Fed’s views of the economy (including housing) and financial sector conditions have noticeably improved since its August statement, consistent with recent statements by Fed Chairman Bernanke that the recession may “technically” be over. While it expects growth to continue to strengthen, the Fed thinks that recovery will be gradual and weakness will remain for awhile. With a weak recovery, the Fed anticipates that inflationary pressures will remain subdued ‘for some time” as considerable slack persists and long-term inflationary expectations are stable.

Despite the improved outlook, the Fed left monetary policy unchanged - and it gave no hint of change in the future. The federal funds target rate will continue to be close to zero (technically speaking, it will remain between 0 and 0.25 percent) and will remain "exceptionally low" “for an extended period” to support the economic recovery and financial sector. (In the Fedwatching world, many interpret "exceptionally low"to mean close to zero, where they are now. However, some have suggested a different interpretation: that higher inflation for a given growth rate may be tolerated than has usually been the case. Some critics had also urged the Fed to clarify what it meant by “extended period”, as some other central banks have done, but the Fed apparently prefers to keep room for maneuver. )

The Fed also confirmed that it would continue to use its extraordinary credit tools in support of the recovery, but continued to map out an exit strategy at the same time. (Not mentioned in the statement, but, according to the financial press, the Fed has held conversations with financial firms about repurchase ("repo") arrangements - credit buy-back arrangements which could be a critical tool to unwind its massive credit facilities.)

In view of the considerable slack in the economy, the Fed has not yet been confronted with the classic choice between growth and inflation. It has as a consequence been able to keep interest rates very low to support growth and at the same time maintain its inflation fighting credentials. Moreover, in the transition from recession to growth, the Fed has so far been able to keep inflationary expectations under control by successfully convincing markets of its ability to unwind the massive resources it has put into the financial sector when appropriate. In the spring, important monetary experts outside the Fed were blunt in their worries that the Fed’s initiatives would be inflationary.

If growth is stronger than anticipated (a sharp “V” shape rather than a more gradual recovery), the Fed may have to decide how much inflation it is willing (and able) to tolerate sooner rather than later. If growth is weaker than anticipated (some notable economists remain worried about a double dip recession, and the prospect of a jobless recovery is very real), the Fed may need to increase or add to the new facilities in its toolkit accordingly. Would its toolkit be sufficient? Money supply growth has been weak and credit has not picked up. Some economists think that monetary policy is too tight – even with the zero bound.