The US FED Launch The QE2 – Beta Version

The US Federal Reserve announced Tuesday that it would spend a relatively small amount of money – about $10 billion a month, economists estimate – buying government debt in an attempt to lower interest rates and boost the alleged economic recovery. Just two months ago, the FED sounded optimistic about the economy. Now the central bank is clearly more worried, and economists say there’s not much more it can do to help.

“In our view, this marks a “baby step” toward renewed quantitative easing later this year.”

Goldman Sachs

In a statement after a one-day meeting, the FED says the pace of the recovery “has slowed in recent months.” After its last meeting in late June, the FED was a lot rosier, saying that the recovery was “proceeding” and the job market actually improving. We’ve heard that one a few times over the last six to 12 months, and as the Econotwist’ Blog and others have pointed out; it is just not true. However, today’s move it’s just a little trial version before the full release of the second round of massive quantitative easing.

The decision to buy government debt, using proceeds from FED investments in mortgage bonds, was a shift from earlier this year, when the US central bank was laying out plans to roll back some of the measures it took during the financial crisis.

At that time, the FED was also preparing a strategy to begin raising interest rates again, a step taken to keep a growing economy from overheating.

The FOMC Meeting

Now, however, the FED has decided to keep its benchmark interest rate near zero.

Other aspects of the statement reinforce the sense of increased uncertainty about economic prospects.

“I don’t think they are going to raise interest rates until it is very clear that unemployment is moving definitively lower and that doesn’t look likely until late 2011,” says Mark Zandi, chief economist at Moody’s Analytics, according to the Washington Post.

Economists points out that buying $10 billion of government debt in a $14 trillion economy is a relatively small move, and they say they do not expect it to have a dramatic impact.

“The FED talked loudly but carried a small stick,” Joel Naroff, president of Naroff Economic Advisors, says.

Adding that while the financial system has the money to lend, banks are unwilling or unable to find suitable loans to make.

Until they do, he says, “the recovery will be softer than anyone hoped for and there may be little the FED can do about it.”

Baby Step Toward The Real  QE2

Analysts ar Goldman Sachs says the FOMC takes a “baby step” toward renewed quantitative easing by deciding to reinvest principal repayments of agency and mortgage-backed securities.

Here’s the main points in Goldman’s comments:

1. The Federal Open Market Committee downgraded its assessment of US growth prospects and reacted, as we thought they might, by deciding to hold the size of their portfolio fixed by reinvesting principal repayments of agency and mortgage-backed securities in “longer-term Treasury securities.” (They already roll existing holdings of Treasury securities.) In an accompanying statement, the New York Fed’s Open Market Desk indicated that purchases would be concentrated in the 2- to 10-year sectors of both nominal coupons and TIPS.

2. In our view, this marks a “baby step” toward renewed quantitative easing later this year or early next, as discussed more fully in last Friday’s US Economics Analyst, though this obviously depends on a view that the economy remains as sluggish as we forecast . Technically, the step marks the removal of a slight bias toward tightening in the sense that it keeps the balance sheet fixed rather than letting it shrink over time. In March, Brian Sack, Manager of the Open Market Desk, indicated that this shrinkage would be in the neighborhood of $200bn from that time through the end of 2011 (roughly a 21-month period, so just short of $10bn per month), though of course this figure may have risen as lower interest rates would have instigated more mortgage refinancing. To our knowledge, the FED has not provided an updated estimate of this run-off.

3. This part of the decision has obscured other changes in the statement, most of which were in the direction anticipated. In particular, the opening statement recognizes a slowing in the pace of recover of both output and employment, the increase in equipment and software is downgraded to “rising” from “has risen significantly,” and the last sentence is revised to recognize that the pace of recovery is apt to be “more modest …. than had been anticipated.” On the other hand, the committee removed the statement that “financial conditions have become less supportive of economic growth.”

4. Changes in the inflation paragraph were inconsequential, removing references to declines in prices of energy and other commodities but continuing to note “measures of underlying inflation have trended lower.” The main thing to note here is that the committee chose to keep this idea in the statement despite upward revisions to the core PCE index. Those revisions preserve the sense of disinflation, but from a slightly higher position than previously.

5. Kansas City President Thomas Hoenig renewed his dissent to the “rate commitment language,” which remained unchanged word for word, and extended the objection to the decision to reinvest.

(Source: Zero Hedge)

FED Have Lost Confidence

Barclays’ analysts, who was among them who believed there were no chance in hell the the FED would don anything, says in today’s statement that the action shows that FOMC is loosing confidence in the strength of the recovery.

Here’s the statement from Barclays:

* Changes to the FOMC statement indicate that the Fed has lost some confidence in the strength of the recovery. In order to “help support the economic recovery,” the Committee voted to keep the Fed’s holdings of securities at its current level by “reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.” The statement, as expected, also retained the language indicating that the federal funds rate is likely to remain exceptionally low for an extended time.

* In respose to the incoming data received since the last meeting, the FOMC indicated that “the pace of recovery in output and employment has slowed in recent months.” The Committee continued to indicate that business spending remains robust while household spending remains constrained by “high unemployment, modest income growth, lower housing wealth, and tight credit.” The FOMC expressed its unease in the state of events by noting that “the pace of economic recovery is likely to be more modest in the near term than had been anticipated.” In other words, the Fed does not appear to view the recent slowing of activity as simply a soft patch in the recovery.

* On the inflation front, the statement removed the language suggesting that lower energy and commodity prices were pushing inflation lower in favor of past language stating that inflation is likely to remain subdued and with stable inflation expectations.

* The statement noted that the maturing principal and interest from agency debt and agency mortgage-backed securities will be reinvested into “longer-term” Treasuries. Subsequent guidance provided to the Open Market Desk at the FRBNY indicates that the Fed will concentrate its purchases in the two- to ten-year portion of the curve. This is similar to the operating procedures put in place under the original Treasury purchase program, which amounted to $300bn. Furthermore, the directive states that the Desk should keep holdings of securities at current levels, which was $2.054trn as of August 4, according to the most recent H.4.1 data.

* Finally, if the FED has indeed lost a measure of confidence in the strength of the recovery, the change in strategy towards keeping the balance sheet at an elevated level will likely lead to increased speculation about additional asset purchases at coming meetings. Our view is that simply reinvesting the proceeds from maturing agency securities will not provide much additional stimulus and, should the outlook continue to worsen, then the FED will likely initiate a new round of asset purchases, most likely in Treasury securities.

Oh yes, baby! There’s a big boat coming….

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