With equity markets reeling, the Fed clearly felt that it had to do something at this meeting, though with little if any genuine ammunition left, it has chosen to indicate rates on hold until at least “mid-2013”, replacing the previously vague statement “for an extended period”. The committee no doubt felt that doing nothing at this meeting would result in a further equity market sell-off. And having previously set out their rationale for QE as being an anti-deflation policy, a further bout of quantitative easing would have been seen as too transparently aimed at propping up an ailing stock market. Instead, committing to keeping rates on hold for such a long time (at least as long as previous market expectations, and maybe a little more), could help to keep long maturity bond yields down, and provide more of an indirect equity boost. That said, with 10 year yields previously hovering below 2.5%, even the merits of this policy look a little strained.
The Fed has also significantly downgraded their language on economic growth, acknowledging the substantial downward revisions accompanying the 2Q11 GDP release. They also pull few punches in their consideration of the labour market, despite the slightly better than expected July payrolls. In their consideration of future growth, they also take a more downbeat view, attributing only some of the recent weakness to the supply disruptions stemming from the Japan disaster.
On inflation, the text has also switched its focus from underlying inflation, to measures including energy. And here, they find the inflation picture less threatening. Several Fed members have been arguing that it makes no sense to keep ignoring food and energy prices. And whilst they might be right, the timing of this switch at time when core inflation is moving steadily higher, but headline inflation is poised to show some declines, seems a bit cheeky to say the least. Some might see this as a clear loss of anti-inflation credibility.
Moreover, the decision to fix a hard date onto the earliest that rates might be raised was obviously highly contentious. 3 members, Kocherlakota, Fisher, and Plosser dissented from this decision, breaking the convention that even when there is broader dissent, only one member puts their head over the parapet. With such high levels of dissent, the hard-dated commitment for low rates may lack the credibility it needs to provide a long lasting stimulus through lower long-dated bond yields. Though for the time being, we don’t think yields are the slightest constraint on the economy, and this approach is more token than real.
Source: ING Bank