Waving the Fed’s Wand

Story Highlights:

• The FOMC left the Federal Funds target rate unchanged and lowered their economic forecasts Wednesday, as expected.
• Following the announcement, Bernanke held a press conference in an attempt to elucidate the Fed’s motivation behind monetary policy decisions.
• In a complex, global world monetary policy isn’t the magic wand some seem to believe.

As expected, the Federal Open Market Committee (FOMC) left the Federal Funds target rate unchanged at 0-0.25%and lowered its economic forecasts Wednesday. In its statement, it also retained the “exceptionally low levels for the federal funds rate for an extended period” language, suggesting it’s unlikely to hike rates in the immediate future. Further, the FOMC indicated it plans to end QE2 on schedule with no hint of further easing. This doesn’t mean the money supply will start to radically contract or QE2 will be reversed—on the contrary, the Fed will continue reinvesting principal payments from its current holdings back in Treasurys to maintain the size of its balance sheet.

The Fed indicated it still sees soft economic growth and commodity-driven inflationary pressures as transitory, noting the economy has been weaker than it previously expected but should pick up in the coming quarters. It also expects unemployment to resume its gradual decline and inflation expectations to remain stable. As we’ve said, none of this really comes as a surprise—the Fed’s been pretty open recently when it comes to telegraphing its views and expected actions.

Following the announcement, Mr. Bernanke stepped into the Fed’s second ever press conference—another attempt to add transparency to Fed actions. All too commonly, folks view the Fed with a sense of mysticism. If you asked most folks familiar with the Fed why it was created, they’d likely say “to control inflation and accommodate growth.” But that wasn’t the case until Jimmy Carter signed the Humphrey-Hawkins Act. The Fed was actually created as the lender of last resort. Yet most of the attentionthese days is on the dual mandate Humphrey-Hawkins created.

Even beyond that, just the word “Fed” evokes tons of overstatements, contradictory perceptions and myths surrounding it and its power. It’s common these days (though not unprecedented by any stretch) to hear folks claimthe Fed’s solely driving the current economic recovery—and hence, it’s fake. While monetary policy certainly plays a (very real) role in influencing economic growth, there’s no magic lever the wizard behind the curtain pulls that “fixes” unemployment or suddenly spurs economic activity—or else why would we ever have recessions?

The Fed can really only use the tools at its disposal (for example, changing reserve requirements, changing the discount rate and buying or selling Treasurys) to attempt to stem or spur the economic engine—attempt being the operative word. And nothing prevents other factors from intervening. The economy’s an incredibly complex animal, after all—and fully global! So the assumption the Fed calls all the shots and the economy does its bidding isn’t reflective of a much more complex, global reality. Look no further than QE2 for proof. While it likely hasn’t done much (if any) harm thus far, it’s hard to make the case QE2 has had hugely positive effects on the US economy. Increased liquidity and loose monetary policy made sense coming out of 2008’s downturn—meaning we’ve seemingly learned one of the Great Depression’s larger lessons (that periods of economic weakness certainly don’t make for great times to tighten money supply). But folks often forget: While increasing liquidity on one hand, the Federal Reserve started paying interest on bank reserves on the other—creating incentive for banks, who are currently a bit lending-shy, to park reserves and earn risk-free interest rather than lend that money out in an ever-changing regulatory environment. A perfect illustration that the Fed’s monetary policy isn’t the only input into the US economy.

Overall, Wednesday’s Fed meeting and press conference paint a fairly stable picture—QE2 will end as expected, the Fed will maintain easy monetary policy given continued weakness in areas like housing and employment and banks will hold onto their reserves barring unforeseen incentives to increase lending. And if nothing else, that picture doesn’t likely bother markets much one way or the other. Longer term, surprises move markets most, and thankfullythe Fed’s provided few of them lately.