Wednesday, February 20, 2013

January FOMC Minutes: Your Head Will Spin
The minutes of the January 29-30 FOMC meeting were released today. If the economy improves, then more members of the committee are likely to push for ending or phasing out quantitative easing. If the economy remains weak, then the Fed is likely to continue purchasing $85 billion per month in Treasuries and mortgage-backed securities (Fig. 1 and Fig. 2). So what should we be rooting for?

If economic growth remains lackluster, there will be mounting concerns that the Fed’s ultra-easy monetary policy is losing its punch and that providing more of it won’t help. Self-sustaining economic growth should be bullish for equities. However, the market has become addicted to injections of QE (Fig. 3). If they are withdrawn too rapidly, the market might go through withdrawal. The internal debate at the Fed about phasing out QE already seems to be unnerving investors. If the pace of economic activity does pick up, the worry will be that inflationary expectations will rise, forcing the Fed to reverse course. That would push bond yields higher, which could put the brakes on any housing-led economic boost (Fig. 4).

The latest minutes reported: “Several participants noted that a very large portfolio of long-duration assets would, under certain circumstances, expose the Federal Reserve to significant capital losses when these holdings were unwound….” Furthermore, “a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability.” In other words, rising stock prices and falling yields on junk bonds suggest that the Fed might be pumping air into asset bubbles again.

According to the latest FOMC minutes, Esther George, president of the Kansas City FRB, was the sole dissenter, voting against continuing QE because of her concern about “the risks of future economic and financial imbalances.” She explained her views in a 1/10 speech that I previously reviewed. I also previously reviewed a 2/7 speech by Fed Governor Jeremy Stein in which he warned that some credit markets are showing signs of potentially excessive risk-taking.

On Friday February 22, Bloomberg reported that Fed Chairman Ben Bernanke “minimized concerns that the central bank’s easy monetary policy has spawned economically-risky asset bubbles in comments at a meeting with dealers and investors this month….” On January 14 at the University of Michigan’s Gerald R. Ford School of Public Policy, he said:
There’s a lot of disagreement about what role monetary policy plays in creating asset bubbles. It is not a settled issue. Our attitude is that we need to be open-minded about it and to pay close attention to what’s happening. And to the extent that we can identify problems, you know we need to address that.
He concluded that the “first line of defense” if bubbles emerge “needs to be regulatory and supervisory” actions rather than changes in monetary policy.

If all this is starting to make your head spin, you are not alone. In my opinion, the Fed won’t waver from its current course of ultra-easy monetary policy until Ben Bernanke’s term as Fed Chairman expires on January 31, 2014. If he isn’t reappointed or if he retires, odds are that either Janet Yellen or William Dudley will replace him. This troika has led the super doves on the FOMC. The latest minutes undoubtedly reflected their collective view as follows:
A few participants noted examples of past instances in which policymakers had prematurely removed accommodation, with adverse effects on economic growth, employment, and price stability; they also stressed the importance of communicating the Committee’s commitment to maintaining a highly accommodative stance of policy as long as warranted by economic conditions. In this regard, a number of participants discussed the possibility of providing monetary accommodation by holding securities for a longer period than envisioned in the Committee’s exit principles, either as a supplement to, or a replacement for, asset purchases.
(Based on an excerpt from YRI Morning Briefing)

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