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The most interesting, indeed shocking, thing about the Federal Open Market Committee's policy statement wasn't what was said but was left out.
What the Federal Reserve's policy-setting panel said after its meeting Tuesday was nearly identical to what it said after its Nov. 3 confab. What was omitted was any mention of what happened in between the two get-togethers.
According to the latest statement, "the Committee decided today to continue expanding the holdings of securities as announced in November." Then, the FOMC formally said it would purchase an additional $600 billion of Treasuries at a pace of $75 billion a month through the end of the second quarter of next year. The plan was dubbed QE2 for the second phase of quantitative easing, the high-falutin' term for the Fed's buying of government securities to expand liquidity. (The first was its $1.7 trillion purchase of Treasuries, agencies and mortgage-backed securities in 2009-10.)
The aim of QE2 has been to lower medium-to-longer-term interest rates since the Fed's main policy variable—the overnight federal funds rate—has been pinned near zero for two years. But since the Nov. 3 FOMC meeting, Treasury yields have done precisely the opposite of what the Fed intended. The two- and five-year note yields have nearly doubled, to 0.65% and 2.07%, respectively. The benchmark 10-year note yield is up a full percentage point, to 3.47%, a seven-month high.
That would suggest QE2 has run aground. The Fed's defenders point to the rally in risk assets, with stocks hitting a two-year high and record corporate-bond issuance, as evidence the policy is working as intended. Investors are venturing out of the safe harbor of low-yielding government securities into the open waters of riskier investments.
Among those would be commodities, which have surged across the board since early November. While the Dow Industrials are up 15% since Fed chief Ben Bernanke started talking about expanded securities purchases in late August, crude oil is up 17%. So, the investing class is benefitting while those who watch the prices at gas stations more closely than the crawl on CNBC are seeing their discretionary spending pinched.
For its part, the FOMC says household spending is "increasing at a moderate pace, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit." That rising food and energy costs may also be hurting isn't acknowledged, even though $4-per-gallon gasoline was the log that broke the back of the consumer in 1982.
Perhaps more understandable was the omission of the fiscal plan hammered out between President Obama and Republican lawmakers. The deal, which staves off big income-tax hikes slated to take place with the scheduled Dec. 31 end of the Bush-era rates, passed its first procedural hurdle in the Senate handily.
Prospects for the tax plan's passage has economists raising their 2011 real gross domestic product growth forecasts by 0.5 percentage point on average, to over 3% and as high as 4%. The fiscal boost would suggest less need for the monetary expansion of QE2. Simply the lessening of uncertainty should be supportive of growth.
Again, there's no mention of this important development in fiscal policy by the FOMC. Of course, it's not a done deal. Moreover, the Fed doesn't want to be seen meddling in the political decisions over tax policies. Cynics would retort that QE2 is intertwined with fiscal policy by buying even more Treasury securities than the federal government will be selling to fund the budget deficit through mid-2011. That would appear to be debt monetization, which is the modern equivalent of printing money—something Bernanke asserted to a credulous 60 Minutes correspondent the central bank wasn't doing because it wasn't rolling off sheets of greenbacks.
In other words, the FOMC was sticking to its guns about the need to add $600 billion in liquidity to a banking system awash in nearly $1 trillion in excess bank reserves. That's even though QE2 is not lowering the yields on the Treasury notes it is buying and, in the process, not keeping mortgage lending rates from rising. The key reason is that unemployment is not being reduced along with other favorable economic indicators. The Fed's so-called dual mandate calls for it to "foster maximum employment and price stability," as the FOMC statement points out.
That mandate could be supplanted or at least changed in favor of one focused on sound money and price stability. Shifts on Capitol Hill and the FOMC could move in that direction in the new year.
On the latter score, the rotation among Fed regional presidents on the FOMC will mean Kansas City Fed head Thomas Hoenig, a perennial dissenter in favor of a less expansionary monetary policy, will come off. But coming on in 2011 will be two and possibly three dissenters: Charles Plosser of Philadelphia; Richard Fisher of Dallas; and Narayan Kocherlakota of Minneapolis. The last of the trio is least well-known, but he recently posited that fiscal actions could substitute for monetary policy, which, he noted "has done all it can do, pretty much." Assuming the Obama-GOP tax package gets approved, he might not favor such an easy Fed policy.
Moreover, in the new Congress, Bernanke is likely to face much tougher questioning than he's used to equally ignorant TV magazine reporters or Congressman. With the Republican takeover of the House of Representatives, Ron Paul will chair the monetary affairs panel. The Texas libertarian has been a voice in the wilderness calling for sound money and abolition of the Fed. For the first time, a Fed chairman won't treat Rep. Paul dismissively.
So, if the Fed is likely to face greater criticism in 2011 for being too easy, better to front-load the stimulus in 2010. And for its final meeting of the year, the FOMC would turn a blind eye to the effects, or lack thereof, from QE2. By providing maximum monetary thrust in late 201o and early 2011, the economy will feel the greatest effect in 2012. In case you didn't know, that's an election year.
So, it may be that the political calendar explains the sweep of Fed policy at least as well as anything else. The third year of a presidential term historically is the best one for risk assets such as stocks. Bernanke & Co. seem to be doing their damnedest to keep that record intact.
Comments: E-mail randall.forsyth@barrons.com
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