Three Fed Speakers Argue for Continued Fed Action

On Thursday and Friday, three Federal Reserve speakers offered their views on the monetary stimulus programs we have in place. Their comments all aligned with each other, with substantial overlap, so they are perhaps best viewed in aggregate. First,

of the Boston Fed spoke at Babson College on November 1.

of the Atlanta Fed spoke at the Chattanooga Downtown Rotary, also on November 1. Lastly,

of the San Francisco Fed spoke in Salt Lake City to community leaders today. Lockhart and Williams are currently voting members of the policy-setting Federal Open Market Committee. Rosengren does not currently have a vote but will rotate onto the committee in 2013. Each of the speakers reinforced the need for the Fed's unconventional monetary policy tools. These include the bond purchases known as quantitative easing and the extension of maturities in the Fed's existing portfolio, known as Operation Twist. All see economic growth as below the economy's potential and that inflation is likely to remain near the Fed's two percent long-run target. Noted were the effects of the programs in reducing interest rates for mortgages and auto loans, in particular, as well as for corporate borrowing. Focusing more on consumers, however, the drop in mortgage rates has helped both housing sales and construction, leading to increased home prices and economic activity. Lower rates for auto loans similarly boosted new car sales and production.These have a direct and indirect effect on the economy and confidence, leading to a “virtuous circle” of improvement. But we are a long way from reaching full employment, and thus, continued action by the Fed is warranted. Lockhart notes the following excerpt from the recent policy statement following the last FOMC meeting (the emphasis is his): “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate

in a context of price stability.” Note the open-ended nature of the Fed's actions to buy bonds to reduce longer-term interest rates. Rosengren would prefer to continue those purchases until unemployment falls to 7.25 percent, which he says would require GDP growth of three percent - a full percentage point more than what we have now. He emphasizes that this is not a “trigger,” only a point at which to examine whether further policy tools are appropriate. The unemployment rate might need to fall to 6.5 percent, he says, for inflation to fully develop. Each of the three Fed speakers emphasized the controlled nature of inflation. Bond purchases, they say, would not increase inflation because unemployment is so low. Inflation expectations, an ingredient in determining the direction of inflation itself, are also low. The topic of inflation is of considerable interest to investors. Consider, though, the reasons why quantitative easing – despite the massive increase in bond purchases by the Fed – has not sparked inflation. The reason is because the funds injected by the Fed into the financial system have not found their way into the real economy. They are sitting, unused, in banks' excess reserves, parked right back at the Fed, earning 0.25 percent interest with no credit risk. That is as the Fed intended, as the Fed's goal was to reduce longer term interest rates, not increase the money supply. An increase in the money supply could, in some circumstances, be inflationary. However, when the Fed buys a bond from an investor or a financial institution, the cash from those funds is then deposited into the banking system. Those funds can then be used to purchase another financial instrument, but again, the cash stays in banks' excess reserves, not in cash in circulation or in demand deposits. In fact, money supply hasn't grown significantly. And since the savings rate is positive, though low, we know that investors are not selling bonds to the Fed and to make household purchases. Similarly, we know that corporations have been hoarding cash due to uncertainty about business conditions. The only way those funds from the Fed's bond purchases could become inflationary is if banks were to lend those funds out. There is not enough demand for new loans nor are there sufficient creditworthy customers for bank lending to increase the money supply enough to cause inflation. And the Fed can easily increase the interest rate on excess reserves to restrain bank lending, if we get to that point. Thus, these three Fed speakers are comfortable with continued quantitative easing. They acknowledged the novel nature of its actions as the Fed ponders its eventual exit strategy. The Fed sees enough headwinds, such as from Europe or fiscal tightening here at home, as reason to continue providing whatever support it can until we have a lower unemployment rate.