FOMC WARMS UP THE HELICOPTER / ROUBINI GLOBAL ECONOMICS - WEDNESDAY NOTE ( VERY HIGHLY RECOMMENDED READING )

FOMC WARMS UP THE HELICOPTER

Greetings from RGE!

This week we've been parsing the statement from the August FOMC meeting to anticipate the Fed's next move. So far, all signs point to an impending monetary policy shift that matches the predictions we laid out in our Q3 2010 Outlook for the U.S. economy.

Prior to the August 10 meeting, the emergence of a string of unimpressive economic data—including a dismal jobs report, examined in this RGE Analysis—put significant pressure on the Fed to show some cognizance of the stalling recovery. As expected, the Fed maintained its pledge to keep the federal funds target low for an extended period, but it also announced that the principal payments on its mortgage-backed securities (MBS) and agency debt would be reinvested in Treasurys. This implies that the Fed will cap its security holdings at current levels, ending the passive tightening from the runoff of its portfolio.

We've been seeing the Fed laying verbal groundwork for further monetary stimulus, which we consider warranted, and the latest announcement appears to be another signal of a forthcoming gradual policy shift. On its own, the latest move is likely to have limited implications for the broader economy. More importantly, the decision to reinvest the repayments in Treasurys reflects the preference many FOMC members have expressed for an expeditious return to the Fed’s traditional Treasurys-only portfolio.

We aren't the only ones who have been saying the Fed needs to credibly commit to providing additional monetary stimulus to boost demand and alleviate deflation risks. One of the Fed's own, St. Louis Fed President James Bullard, in late July published a report highlighting research that indicates that “the U.S. is closer to a Japanese-style outcome today than at any time in recent history.” Bullard warns that with the nominal interest rate at zero and inflation well below the Fed’s implicit target and falling, there is a risk of policy becoming passive and getting the economy mired in an extended period of low inflation and nominal rates. As a solution, Bullard calls for a policy shift to quantitative easing through the purchase of Treasury securities, modeled after the UK, rather than the recent MBS program. The Fed's latest move represents the first step in that direction.

Now we're speculating on how effective these and other alternative ways to provide additional policy stimulus will be.