When the Fed talks, people listen. The FOMC (Federal Reserve Open market Committee) met yesterday, and announced that they will continue to keep the rates they offer to their best clients (the big banks) at or close to zero and will keep rates low for an extended period of time. This part was expected. The Fed has kept similar wording in their statement for over a year now. What was new was the wording suggesting that the economy has softened over the last several months and the pace of recovery is likely to be “modest” in the near term. They go on to say that the measure of inflation is at levels below what is needed for price stability. In plain English, this means that the Fed is more concerned about deflation (prices spiraling downward), than a return of inflation (prices moving higher). The Fed will continue to reinvest principal from securities (Treasury and mortgage bonds) back into new securities to maintain the same level of support. They also said they were “prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.” This is another way of saying they may be ready to do another round of quantitative easing. The markets were choppy after the release, but the net result was mortgage bonds ended the day with a big gain, meaning mortgage rates are trending down again (we are in the middle of a range right now).

Quantitative easing means the Fed would pump more money into the system. They did this last year by buying Treasury bonds and 1.25 trillion dollars of mortgage backed securities. The danger in this move is that when more money floods the system, it can trigger inflation, and once inflation takes hold it is hard to stop. By saying that the level of inflation is too low, they are saying that this a battle for later, and they are willing to risk some inflation to get the economy moving again. One Fed member voted against this (an inflation hawk) but all the other members were in agreement. So it probably won’t come right away, but the next time we get a new round of bad economic news, don’t be surprised if the Fed steps in and announces a new round of buying mortgages and treasuries. The bottom line is that fear is still in the air, and the consumer is still strapped. Mortgage rates are likely to remain low for quite some time.

Here is the Fed statement in its entirety:

Information received since the Federal Open Market Committee met in August indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts are at a depressed level. Bank lending has continued to contract, but at a reduced rate in recent months. The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be modest in the near term.

Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period. The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings.

The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.

Voting against the policy was Thomas M. Hoenig, who judged that the economy continues to recover at a moderate pace. 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 will lead to future imbalances that undermine stable long-run growth. In addition, given economic and financial conditions, Mr. Hoenig did not believe that continuing to reinvest principal payments from its securities holdings was required to support the Committee’s policy objectives.

Peter Thompson 630-479-6424

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