The FOMC Minutes Show that Real Policy Action was Indeed Debated in August Meaning that Action Looks Likely in Three Weeks

Last night saw the publishing of the minutes from the August meeting of the Federal Open Markets Committee -FOMC- and they were eagerly awaited for three reasons. Added to the underlying issue of a slowing US economy we have two more factors. Firstly a speech at Jackson Hole by the Chairman of the FOMC which hinted at further action and secondly the fact that 3 members of it had dissented from its policy pronouncement. This level of dissent had not happened for twenty years and in percentage terms is in fact more pronounced than that as currently the FOMC has two unfilled Governors posts meaning that it is below its usual complement.

It is my opinion that the FOMC has as its priority the employment/unemployment situation in the United States. I believe that it follows these measures more closely than economic growth and that currently it also takes priority over the inflation target. Accordingly I was not surprised to see quite a few references to it and we start with a rather grim opening. - Participants noted a deterioration in labor market conditions, slower household spending, a drop in consumer and business confidence, and continued weakness in the housing sector. - That bit did not leave much out did it? And we might already be expecting policy action but there was another section which highlighted worries over the employment position. - Meeting participants generally noted that overall labor market conditions had deteriorated in recent months……. A couple of participants commented that the exceptionally high level of long-term unemployment could lead to permanent negative effects on the skills and employment prospects of those affected. - So we get an admittal of the fact that the employment situation is worsening and furthermore that there could be long-term effects from this. As the main monetary stimulus programme which became called QE2 had only ended just over a month before this meeting,the FOMC was beginning to face up to a deteriorating situation after it has made some US 600 billion dollars of asset purchases. Some members also faced up to the issue that the underlying employment situation may in fact be worse than implied by the headline figures. - Other participants remarked that the declines in the unemployment rate that have occurred over the past year appeared to reflect primarily declines in labor force participation rather than significant gains in employment. - What they mean by this is that recorded headline unemployment falls if some people give up looking for work rather than find new jobs. This is quite a different situation as it moves us from a hopeful new jobs scenario to one where those who might want a job get so demoralised by their search for work and their failure to get it that they give up and fall out of the numbers.There certainly has been some evidence of this.

We got the usual range of policy alternatives.

- Some participants noted that additional asset purchases could be used to provide more accommodation by lowering longer-term interest rates. -

- Others suggested that increasing the average maturity of the System's portfolio–perhaps by selling securities with relatively short remaining maturities and purchasing securities with relatively long remaining maturities–could have a similar effect on longer-term interest rates. -

- A few participants noted that a reduction in the interest rate paid on excess reserve balances could also be helpful in easing financial conditions -

There are issues with each of these options and we we start with QE3 the main one is that its very existence implies that QE,QE2 and QE-lite did not work,otherwise why is it necessary? The issue of an Operation Twist mark two is that economists are divided into two camps about its first incarnation which was back in the Camelot days of JFK and one is that it had very little impact and the other is that it had no impact. So not an inspiring duo! If we look at interest on excess reserves let me explain what they are. As part of its response to the credit crunch the Federal Reserve started to pay interest on reserves held with it as a way of increasing its control of the monetary system. I also suspect it was worried too about the impact of its interest rate cuts and unofficially the possible implications of it offering a zero interest rate! Times are different now are they not? On the 11th of August I was discussing the prospect of negative interest rates in Switzerland and since then Union Bank of Switzerland has started to charge some customers to hold cash with it. So fears of the effect of a zero interest rate turned out to be similar to fears of the millenium bug. Sadly however the underlying economic problems remain as they did not turn out to be a mirage. Supporters of a change to paying interest on excess reserves feel that stopping it would mean that banks would lend more and therefore lead to an economic boost. Personally I feel that the money might go elsewhere into other financial markets and have all sorts of effects but that we have very little reason to suspect it would lead to more bank lending. After all if an interest rate move of 0.25% could fundamentally improve things we would be in an economic nirvana right now after all the multiples of it we have had (22 in the UK for example).

I argued on the tenth of August that the three dissenters may have stopped further policy moves at the August meeting and I still believe this and it was interesting to note that at the meeting it was decided that the next one would be for two days. I suspect that there was quite a debate and possible even a row!

Mr. Kocherlakota gave a speech yesterday and in general it was as hawkish as one might expect with an exception described by the sentence below. - So, I plan to abide by the August 2011 commitment in thinking about my own future decisions. - Frankly this is a little bizarre. The media have also zeroed in on another section of his speech but in their rush to reach a conclusion have ignored the first section of the quote below. - But some observers argue that core PCE inflation is only temporarily high because of the tragic events in Japan or transitory spikes in commodity prices. If so, the disinflationary pressures of 2010 should soon reappear in the form of a sharp decline in current and expected core PCE inflation rates. In that eventuality, increasing policy accommodation might well be appropriate. - The “some observers” makes quite a difference to quoting what follows and looking at the speech overall Ben Bernanke will have his work cut out in persuading Mr. Kochlerlokota to change his mind over policy easing in the next three weeks.

It has been my opinion for some time that a quorum for further easing has been building on the FOMC. I suggested on the 6th of May that it was “probable” and on the 8th of June I pointed out this. - Which reinforce me in my view that whilst further monetary easing or QE3 is not especially likely right now it could only be a few months away if the US unemployment/employment situation continues to stagnate or weakens further. - The situation regarding unemployment and employment has indeed weakened since then with several poor monthly jobs reports and week after week of disappointing initial jobless claims numbers. Last weeks number for initial jobless claims was 417,000 continuing a problematic trend which now stretches back some five months. Another weak jobs report would ratchet up the pressure on the FOMC and we only have to wait until Friday to discover the numbers for August but the omens from economic figures we have seen so far are not good.

The FOMC has in my opinion been too willing to kow-tow to the wishes of financial markets leaving it open to criticism that it is in their pocket. It also raises the problem of how it gets off that particular treadmill as the chorus of calls for a version of QE3 is beginning with the main cheerleaders so far being Goldman Sachs and JP Morgan. It also raises the problem that the so-called solution is being proposed by the same group of people who got us into this mess as the main driver was the failure of the mortage backed securities market driven by guess who? I feel that Ben Bernanke and many of his committee plan to make new policy moves in three weeks time but exactly how this plays out will depend on how firm the dissenters remain and how willing he is to ignore them. If Ben succeeds then we will have a new front in economic policy as it will be rare for such an important decision to be taken with some much dissent. Perhaps they should appoint two new Governors quickly to make the numbers look better! Sir Humphrey Appleby had some advice on such matters ( You do not influence someone, you appoint someone who does not need to be influenced…)

Mr. Kochlerlatoya in his speech explained how a central bank's inflation target could lose credibility. - Imagine that inflation runs at 3 or 4 percent per year for three or four years. The public will then start to doubt the credibility of the Fed's stated commitment to a 2-percent-or-a-bit-under objective. The public's medium-term inflationary expectations will consequently begin to rise. -

For those wondering about the consequences of this the conclusion is both higher inflation and higher unemployment in the medium and long- term.