Fed doves glide through cloudy skies

The US Federal Reserve has presented a generally positive view of the economy but it noted that significant risks remain, with the unemployment rate too high and inflation too low.

The bottom line was that the Fed was more dovish than the market generally anticipated, which gave a short-lived boost to share prices and saw bond yields tick lower. The stock market got a short-term boost but this faltered into the close and at the end of the day, share prices were a touch lower. The US dollar was generally weaker, although the Australian dollar fell further and early this morning is trading around $US0.8990.

In a nutshell, the Fed will keep the federal funds rate in a zero to 0.25 per cent range and will continue its $US85 billion a month bond buying program, which will be made up of $US40 billion of mortgage-backed securities and $US45 billion of longer-term Treasury securities.

There was no firm indication of a timeframe for the Fed to step down the level of bond buying and it said the quantitative easing could actually rise if the economy weakened. Specifically, the Fed noted that it “will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes”.

The super stimulatory monetary policy settings will remain in place until the unemployment rate falls, perhaps to around 6.5 per cent, and inflation increases to a pace nearer the 2 per cent long-term objective.

In other words, the key factors behind the relative dovishness of the Fed remained the persistently high unemployment rate and its concern about the low inflation climate. Indeed, the Fed statement noted, “inflation persistently below its 2 per cent objective could pose risks to economic performance”. In terms of the labour market, the Fed noted the 0 to 0.25 per cent target for the Fed funds rate would remain appropriate “at least as long as the unemployment rate remains above 6.5 per cent”.

In the end, the Fed policy actions will be determined by the flow of economic news, as it always is. It is only that in the current cycle, the outlook is more cloudy than normal and that the quest for economic recovery has been particularly difficult to nail down. This is what accounts for the lack of firm direction from policy makers.

The Fed’s assessment of economic conditions followed the release earlier in the day of a better than expected 1.7 per cent annualised GDP growth rate for the June quarter, up from 1.1 per cent from the March quarter. While still below trend, the performance of the economy is generating a reasonably solid rate of job creation, with the ADP Research Institute reporting 200,000 new jobs created in July. The official labour force data are released this Friday and the market consensus is for around 190,000 new jobs in the months and for the unemployment rate to remain around 7.5 per cent.

Westpac senior economic James Shugg took a less optimistic view of the recent US data, noting on Twitter that “when the Fed started QE3 in September last year the economy was growing at 3.1 per cent year; it has now slowed to less than half that pace at 1.4 per cent” and that “the 0.8 per cent core PCE [personal consumption expenditure] deflator is second lowest ever and the rate that triggered the deflation scare and QE2 in late 2010”. 

These comments from Shugg sum up the situation perfectly: while the economy is growing, it is still not fast enough to lock in a lower unemployment figure, a point confirmed by an inflation rate that is too low.

And while ever this remains the scenario in the US, the Federal Reserve will maintain super easy monetary policy.