The US Federal Open Market Committee decided to keep the federal funds target rate unchanged at 0.00% to 0.25%, AND announced an unprecedented decision that interest rates would remain ‘exceptionally’ low until at least mid-2013. I don’t think the Fed has ever set a date on fixing interest rates into the future. An interesting and bold move, but three of the committee members voted against the decision to set a date.
The Fed has also acknowledged the extended soft-patch in the economy. While the Fed is not saying the economy is going back into a recession, they are indicating that economic growth will remain low for a long period of time.
The decision on Tuesday is obviously very favourable for the bond market, but if the Fed is right on the growth outlook, many equity analysts will probably need to revise down their company earnings estimate for the remainder of 2011 and 2012, which is obviously not good for equity market valuations.
I think the latest policy change (setting a date) is a better option than announcing QE3, but ultimately the Fed has almost run-out of policy options to stimulate the economy. More positively, by providing long-term certainty on sustained low interest rates the Fed may be able to inspire some confidence further-out.
The equity market initially reacted poorly to the announcement because it was probably hoping for QE3, and may also be concerned by the Fed’s very negative outlook for the economy. Certainty on sustained low interest rates will take some time to have a beneficial effect, but hopefully the Q3 economic data gets slightly better. The bond market, on the other hand, has reacted very quickly to the idea of sustained low interest rates.
In making the decision the FOMC made the following key comments about the outlook for growth and inflation:
Growth:
- Economic growth so far this year has been considerably slower than the Committee had expected.
- Indicators suggest a deterioration in overall labor market conditions in recent months, and the unemployment rate has moved up.
- Household spending has flattened out, investment in nonresidential structures is still weak, and the housing sector remains depressed.
- Business investment in equipment and software continues to expand.
- Temporary factors, including the damping effect of higher food and energy prices on consumer purchasing power and spending, as well as supply chain disruptions associated with the tragic events in Japan, appear to account for only some of the recent weakness in economic activity.
- The Committee now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting and anticipates that the unemployment rate will decline only gradually.
- Downside risks to the economic outlook have increased.
Inflation:
- Inflation picked up earlier in the year, mainly reflecting higher prices for some commodities and imported goods, as well as the supply chain disruptions.
- More recently, inflation has moderated as prices of energy and some commodities have declined from their earlier peaks.
- Longer-term inflation expectations have remained stable.
Policy change:
- The Fed is now saying that the outlook for inflation and growth is such that it warrants exceptionally low levels for the federal funds interest rate at least through mid-2013.
- The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings (see chart on the Fed’s holdings of mortgage backed securities).
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