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Bernanke’s Quantitative Easing Challenge

Saturday, June 20, 2009

The focus of the Federal Open Market Committee’s meeting will be on how recent financial market developments, mainly in reaction to a perceived overly expansionary longer-run budget policy, are putting the incipient recovery at risk.

Financial markets are eagerly anticipating the Federal Open Market Committee’s next meeting on June 23 and 24 for additional clarification as to how the Fed is to implement the unorthodox monetary policy approach that it announced earlier in the year. In March 2009, after having reduced the federal funds rate to 00.25 percent, the Fed indicated in rather general terms that it would be buying up to $1,450 billion in mortgage-backed securities and up to $300 billion in U.S. Treasuries. It indicated that it would be doing so with a view to bringing down long-term interest rates to support an economic recovery.

Since the FOMC’s last meeting there has been clear evidence that the pace of the economic recession is moderating markedly and there are now glimmers of hope that the U.S. economy might begin recovering in the second half of the year. However, recent financial market developments, mainly in reaction to what is perceived to be an overly expansionary longer-run budget policy, are now putting the incipient recovery at risk. For contrary to what the Fed would have liked to see, long-term U.S. Treasury rates and the all-important 15- and 30-year fixed term mortgage interest rates have now increased by around a full percentage point over the past few weeks. At the same time, there has been a renewed weakening in the U.S. dollar that now raises long-run inflation concerns.

The FOMC is likely to maintain its view that the very large gaps in output and labor markets, as underlined by a 9.4 percent unemployment rate, will keep inflation well contained. They are also likely to maintain the view that the ongoing process of household balance sheet rebuilding will make any economic recovery moderate by historical standards and will be associated with a continued increase in unemployment. These considerations are likely to lead the FOMC to intimate that it sees no immediate inflation risk and that it has no intention to raise its short-term interest rates anytime soon.

On the issue of quantitative easing, the FOMC will be sensitive to the risk that more aggressive purchases of mortgage-backed securities or of U.S. Treasuries could be interpreted by the market as signaling that the Federal Reserve might be inclined to monetize at least part of the large budget deficits that are in prospect over the next few years. This consideration is likely to incline the Fed to intimate that it will continue its program of bond purchases at much the same pace as has been in evidence since that program’s inception last March even though this might entail higher long-term interest rates than the Fed would like to see.

Among the economic indicators at which the FOMC will be looking are the following:


(a)    The recent sharp increase in long-dated U.S. Treasury interest rates to over 3 ¾ percentage points and the corresponding steepening in the yield curve.


(b)    The renewed weakening in the U.S. dollar to its lowest level this year.


(c)    A clear moderation in the pace of job losses from over 600,000 jobs a month earlier in the year to around 350,000 jobs lost in May.


(d)   A continued very high level of unemployment as underlined by the fact that those unable to find full time employment in the United States now total more than 16 percent of the labor force.


(e)    A distinct improvement in consumer confidence from the lows reached in March.


(f)     A marked pick up in the purchasing managers’ index.


(g)    A continued very depressed level of housing starts.


(h)    A still very moderate pace of consumer price inflation.


Desmond Lachman is a resident fellow at the American Enterprise Institute. He joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund's policy development and review department.

Image by Darren Wamboldt/Bergman Group and Flickr user talkradionews.

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