August 1, 2012
When you’re running low on ammunition and the enemy is still off in the distance, it’s probably a good idea to hold your fire.
And that’s exactly what the Federal Reserve Board did Wednesday, leaving monetary policy unchanged at least until mid-September when it holds another two-day session to review the latest economic forecast.
The uncertain winds blowing from Europe and Capitol Hill clearly weighed on monetary policymakers’ minds Tuesday and Wednesday as they contemplated further action to deal with an economy that slowed to a 1.5 percent growth rate in the second quarter. That’s well below what is needed to bring down the nation’s 8.2 percent unemployment rate, which under other circumstances would trigger some kind of renewed stimulus on the part of a Fed whose twin legislative mandates are to hold inflation check while maintaining full employment.
But they avoided taking any new actions. “The Fed is holding back until it sees the whites of the eyes of a crisis,” said Diane Swonk, chief economist for Mesirow Financial in Chicago. “Unfortunately, we’re likely to get to that point given Europe and the fiscal cliff risks.”
Though the European Central Bank and national authorities almost weekly issue new pronouncements claiming they’re going to resolve the sovereign debt and bank debt crises plaguing the Euro zone’s southern tier, many market participants fear their efforts will eventually fall short and trigger a global crisis. Even if that’s only a remote risk, the Fed needs to be prepared to deal with such an event, which would quickly reverberate across global markets.
Closer to home, Congress this week may have put off until next year any threat of a government shut-down by adopting a continuing resolution to keep on spending at this year’s rate. But after the election, lame duck legislators will have only two months to deal with the expiration of the 2001 and 2003 tax cuts and the imposition of previously enacted across-the-board spending cuts – so-called sequestration. Those twin hits would throw the economy into renewed recession.
A spending withdrawal of that magnitude, given the current weakness in the economy, will likely translate almost immediately into widespread government layoffs; cutbacks at defense contractors and other firms that depend on government work; and a sharp plunge in stock and bond prices. It could even set off the long-feared flight from U.S. government securities that would send interest rates soaring and potentially freeze private sector credit markets.
Under such a scenario, the Fed would become the only government agency with the capacity to stop the plunge by stepping in to buy government bonds. Most people and market participants may believe the likelihood of that scenario coming to pass are remote – it’s just political posturing in Washington ahead of an election. But even if it is only what economists call a “long tail” risk, the Fed has to have tools available to deal with the possibility.
That helps explain today’s near-unanimous vote for keeping monetary policy unchanged, despite the sluggish economy. The statement, approved 11-1 by the board of governors, called for keeping the federal funds rate near zero and to maintain the Fed’s current bond market activity, which involves swapping short-term maturities for long-term bonds – known as Operation Twist – to push down long-term rates. That lowers interest rate charged industrial, commercial and residential borrowers.
The only dissenting voice came from Jeffrey Lacker of the Richmond Federal Reserve Bank. He balked at supporting the Fed’s statement that it will maintain this accommodative stance at least until the end of 2014. He was reflecting the views of inflation hawks that the super-low interest rates are penalizing savers and risk higher inflation down the road.
“Given the extension of Operation Twist just six weeks ago and the limited new data since then, I was not expecting much more than this,” said Joseph Gagnon, a former Fed official who is now at the Peterson Institute for International Economics, which is funded in part by Pete Peterson, who also provides financial support for The Fiscal Times. “I thought they might change the late-2014 language to mid-2015, but they did not even do that. Their statement today does seem to set up further action in September if the news by then is not noticeably better.”