Central Banks Part 1 : The Fed

Last meeting: December 14, 2010

Prior to last: November 2-3, 2010

Next meeting: January 25-26, 2011

Chairman: Ben Bernanke

Meeting Statement

At its last meeting on December 14, the FOMC maintained the “exceptionally low” for an “extended period” language on the Fed Funds rate, keeping it unchanged at a target range of o to 0.25%. The Fed also noted that it intends to continue its planned $600bn of Treasury purchases, $75bn per month as announced in the November meeting up to June 2011. The Fed also cautioned that it would monitor and evaluate the size of the program on an ongoing basis.

Longer-term inflation expectations were seen as stable but underlying inflation has continued to trend downward.

For the nth meeting now, Kansas City Fed President Thomas Hoenig voted against the policy adopting the view that the economic recovery means that an expansionary monetary policy could spark extremely high levels of future inflation that could destabilize the economy.

Prior meeting minutes

Many market participants worried whether the Fed will complete its stated $600bn in Treasury purchases, citing future inflation as a problem. The Fed minutes from the November 3^rd meeting seem to have clarified its strong commitment to this policy. There are in fact reasons to believe that the Fed has potential to do more if required. The minutes from the Fed meeting included an FOMC videoconference on October 15, 2010 at which the members discussed a several possible easing steps, with the announced program described as an “incremental approach” as opposed to the much talked about shock and awe approach. This terminology only suggests that the stated amount of $600bn is very likely seen as a first installment. Given the Fed’s determination towards easing, the economy would need to improve beyond its forecasted 3.3% level, accompanied by a gradually declining unemployment rate. Such developments seem highly unlikely in the next three to six months.

Outlook

The Fed is still facing extremely sticky unemployment, falling inflation measurements, and extremely low levels of household spending and consumer confidence. It seems highly likely that the Fed will continue and complete its planned QE2 program. I do not think a QE3 will take place. The recovery has been slow, but there is recovery nevertheless. The extension of the fiscal easing should make corporates have a more clear planning horizon which should help staffing and capital budgeting decisions.

I don’t see the Fed tightening happening anytime in 2011, even though the market seems to be pricing in a tightening beginning Q2 2011, as implied by the Eurodollar futures for March and June 2011. A tightening of monetary policy in 2012 Q1 seems more likely. On the other hand, with an imminent fiscal tightening in 2012 or 2013 times ahead for the US seem extremely bumpy.

** The voting members rotate beginning next year. The only dissenter, Kansas City President Hoenig will not be a part of the voting team now. Kansas City, Cleaveland, Boston and St. Louis will be replaced by Chicago, Minneapolis, Philadelphia and Dallas. Minneapolis Fed President Mr Narayana Kocherlakota has some interesting thoughts which I hope to discuss here soon.