August 10th FOMC statement – Shuffling the Deck Chairs or much ado about Nothing

The much vaulted Federal Reserve meeting has come and gone leaving the markets disappointed with the inaction on the part of the Federal Reserve.

Traders and market participants expecting the Federal Reserve to begin unwinding the quantitative easing by decreasing the size of its balance sheet were disappointed. Instead of selling mortgage backed securities into the market possibly raising rates the Federal Reserve has decided to shift the amount of maturing securities and principal repayments into 2-10 year Treasury holdings.

This is not quantitative easing nor is any new money being created. Instead the deck chairs are merely being shuffled around as the Federal Reserve would not like to see mortgage rates rise but see the need to help support Treasury functions.

The most interesting portion of the statement was the ending paragraph with Kansas City Bank President Thomas J. Hoenig stating the following, “who judges that the economy is recovering modestly, as projected. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and limits the Committee’s ability to adjust policy when needed. In addition, given economic and financial conditions, Mr. Hoenig did not believe that keeping constant the size of the Federal Reserve’s holdings of longer-term securities at their current level was required to support a return to the Committee’s
policy objectives.”

The inclusion of this paragraph indicates that there must have been a spirited debate within the policy room between Mr. Hoenig, who is known as a hawk, and his fellow board members who see the need to keep rates low and the balance sheet at current levels. This makes the coming release of the August minutes quite interesting as to the scope and fervor of the debate.

The Federal Reserve has found itself backed into the corner. By leaving rates at 0 they encourage the carry trade and speculation while discouraging lending. Banks are hoping that they can muddle through the current period until their balance sheets are cleaned up to the point where they can begin easing credit and accepting risk.

On the other side of the equation, if they move rates higher the Federal Reserve risks stalling a slow recovery as businesses are wary of adding workers to the payroll.

If rates were to rise, borrowing costs would increase and sending the US Budget deficit to even more stratospheric heights. The flip side is that the banks would earn less on the spread of their Treasury holdings forcing them back into the lending market.

Another danger is the potential for an invisible hand to begin working in the Treasury market holding rates low and capping any potential rise.

The Fed has already taken the first step in terms of tightening by removing the excess stimulus and slowing money supply growth. But further steps need to be taken in the short-term to show that they are serious about moving the economy back onto a sustained growth track.

With other central banks around the world slowing raising rates and removing the excess stimulus the Fed is walking a dangerous tightrope where low rates will encourage the use of the US Dollar as a medium to induce the carry trade for overseas economies as high structural unemployment constraints long-term GDP growth.

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