An Anxious Fed Decided to Give the Economy a Little More Time

Ben Bernanke, FOMC September minutes
Ben Bernanke, FOMC September minutes

The key theme in the minutes from the Fed Open Market Committee's Sept. 20-21 meeting: Officials indicated that a second round of quantitative easing may be needed "before long," but they delayed any moves in September to collect more data and determine how to best to communicate the policy.

A continued, sluggish job market and tepid second-quarter U.S. GDP growth of 1.7% has increased institutional investors' speculation that the Federal Reserve will start a second round of asset purchases, or quantitative easing, the so-called QE2'

The FOMC officials focused on buying U.S. Treasurys and boosting inflation expectations as ways to increase stimulus, the minutes indicated.

"Many participants noted that if economic growth remained too slow to make satisfactory progress toward reducing the unemployment rate or if inflation continued to come in below levels consistent with the FOMC's dual mandate, it would be appropriate to provide additional monetary policy accommodation," the minutes said.

Debate Over Asset Purchases' Effectiveness

However, the minutes added that some Fed officials said the economic benefits of additional asset purchases "could be small in current circumstance," with some some policymakers noting that they thought "additional accommodation would be warranted only if the outlook worsened and the odds of deflation increased materially."

The minutes didn't mention a specific GDP growth forecast, but they noted that Fed economists lowered their U.S. growth forecast for the third straight meeting in September. The Fed now expects the economy to grow at a slower pace in second half of 2010 and in 2011 than it previously forecast.

FOMC members "generally agreed that the incoming data indicated that output and employment were increasing only slowly and at rates well below those recorded earlier in the year," the minutes said. Policymakers viewed recent data on business and household spending as "mixed," adding that residential construction and home sales were "very weak."

"Nevertheless, participants judged the economic recovery to be continuing and generally expected growth to pick up gradually next year," the minutes said.

Investors responded slightly favorably to the latest Fed minutes. The Dow Jones Industrial Average, down about 40 points at 10,970 prior to their release, reversed and erased its loss, trading at 11,014 shortly after the announcement.

"A Very Risky Strategy"

The release of the Fed's minutes occur on a day when Kansas City Fed President Thomas Hoenig reiterated his opposition to another stage of Fed asset buying, calling quantitative easing a "very risky strategy."

"Not knowing what the outcome might be makes quantitative easing a very risky strategy," Hoenig said, in a speech Tuesday at the annual meeting of the National Association foe Business Economics (NABE) in Denver. "It amounts to attempting to fine-tune inflation expectations -- a variable we cannot precisely or accurately measure -- over the next decade."

Hoenig said increasing the Fed's balance sheet by another $500 billion to $1 trillion over the next year, and perhaps keeping the balance sheet at $3 trillion for the next several years, "risks undermining the public's confidence in the Fed's commitment to long-run price stability, a key element of its mandate." Hoenig has dissented in all seven Fed meetings held this year, and he reiterated his recommendation that the Fed raise short-term interest rates and end its "extended period" of low rates.

Ready to Yank the Punchbowl

On Oct. 11, Fed Vice Chairman Janet Yellen, in her first public remarks as the central bank's vice chair, said low interest rates also contain risks for the financial system and the economy. "It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage and excessive risk-taking in the financial system," Yellen said in a speech at the Denver NABE meeting.

"Our goal should be to deploy an enhanced arsenal of regulatory tools to address systemic risk," said Yellen, who was San Francisco Fed president prior to her becoming vice chair in place of Donald Kohn, who retired. "We need macroprudential policymakers ready to take away the punch bowl when the party is getting out of hand," Yellen added.

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Yellen said the Fed is aware that market players won't be overjoyed when the Fed determines that limits and/or risk reduction is needed.

"We know that market participants won't take kindly when limits are set precisely in those markets that are most exuberant, the ones in which they are making big money," Yellen said. Despite that reality, "discretionary interventions will inevitably play a part in macropruential supervision," she added

In sum, the September minutes show a Fed that's keenly aware of both the nation's inadequate GDP growth rate and insufficient job growth, but it also wants to give the world's largest economy more time -- one more FOMC meeting -- to display signs of increased commercial activity before deploying more quantitative easing.