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The Federal Reserve has set its course through midyear, by which time QE2 is all but certain to be completed. But the central bank gave no hints about its policy once the voyage is completed -- or what its ultimate impact will be.
Following its two-day meeting, the Federal Open Market Committee once again released a policy statement that was nearly identical to the previous one. As at its Dec. 14 gathering, the FOMC reiterated its intention to continue its program to purchase $600 billion of Treasury securities by the end of the second quarter. In addition, the panel also repeated that it will maintain its 0-0.25% target range for the overnight federal funds rate, as it has since December 2008, and that it expects "exceptionally low levels" for fed funds for an "extended period."
Which is exactly what everyone expected.
The only change, and one not unexpected, was the lack of dissents among the FOMC's members. That was the result of the annual rotation among the Fed district presidents voting on the Committee. No longer voting was Thomas Hoenig of the Kansas City Fed, who dissented consistently in favor of a less expansionary policy during his stint as a voter last year, in particular against QE2. Charles Plosser of Philadelphia and Richard Fisher of Dallas, two hawkishly inclined Fed presidents, opted not to dissent.
Another small change: the Fed's characterization of the recovery's impact on jobs, or lack thereof. In December, the FOMC said growth "has been insufficient to bring down unemployment." This time, growth "has been insufficient to bring about a significant improvement in labor market conditions." That probably reflects the fall in the jobless rate to 9.4% in December from 9.8%, a totally bogus drop resulting from a decline in the number of job-seekers.
The FOMC did take note of the rise in commodity prices at the latest meeting, but contended "longer-term inflation expectations remained stable, and measures of underlying inflation have been trending downward." A cynic might suggest the Fed's belated recognition of the jump in commodity prices shows the rally has run its course. From the central bank's standpoint, inflation is contained because "core" measures that exclude food and energy costs are up less than 1% year-over-year.
The panel also acknowledged that "household spending picked up late last year," but reiterated consumption "remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit."
"We think they are right," adds Ian Shepherdson, chief U.S. economist at High Frequency Economics. "The 4%-plus in real consumption we expect to see reported for fourth quarter in [Friday's] first estimate of [gross domestic product] will not be repeated in [the first quarter.]"
Fed Chairman Ben Bernanke has been straightforward in his strategy. By expanding liquidity through purchases of Treasury securities, the Fed should lift asset prices, which translates into increased consumer confidence, and in turn, spending. On that score, the central has been successful. Since Bernanke floated the notion of QE2 in late August, the Wilshire 5000, the broadest measure of the U.S. equity market, has increased in value by more than 25%, or $3.2 trillion.
More controversial repercussions of current policy aren't mentioned in FOMC's release. While QE2 is in operation, the Fed's purchases of $600 billion Treasury securities effectively finance the federal deficit, which the latest Congressional Budget Office projections put at a record $1.5 trillion for the current fiscal year. Once that source of demand for Uncle Sam's paper disappears starting in July, what will the impact be? Even with QE2, the benchmark 10-year Treasury note yield is up nearly a full percentage point (to 3.43% Wednesday) since the program was approved in early November. No mention of this seeming anomaly by the FOMC.
The international aspects of QE2 also aren't mentioned, even though the Treasury purchases prompted unusually vituperative criticism of Fed policy from abroad. Conspiracy theorists thought the Fed's real aim was to force China to revalue its currency, the renminbi or yuan.
Here's how that would work: the increase of Fed-generated liquidity would create a surfeit of dollars. In order for Chinese monetary authorities to prevent a rise in the yuan and fall in the greenback, they have to buy dollars by printing more yuan -- a loosening of monetary policy.
But China is coping with an overheating economy that is creating inflationary pressures, so it has been tightening policy. Allowing the yuan to appreciate would resolve this conundrum, and indeed was the argument pressed by President Obama to China's Premier Hu in the latter's recent visit to the U.S.
As noted here yesterday, central banks abroad, especially those in China, India and other rapidly growing emerging economies, are pushing back against the Fed's liquidity expansion, which has driven prices of commodities as well as equities higher. Officials in those countries cannot take as benign a view of higher food and fuel prices, which comprise a much bigger portion of the market basket than for the U.S.
While the FOMC probably will keep its policy directive virtually unchanged at its next meeting March 15, the panel will have to begin to consider post-QE2 plans at its April 26-27 two-day confab. By then, it may become apparent that the higher commodities price will be acting as a vise on consumers' discretionary spending and in turn upon corporate profit margins, which already are at historic highs. Which was the same dynamic seen in 2008, which sent the economy skidding- -- even before the crisis following the failure of Lehman Brothers that fall.
Comments: E-mail randall.forsyth@barrons.com
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