The Fed Is Buying Time—Why?
There is nothing substantively new in the U.S. Federal Reserve's latest statement on its data-driven policy settings. Labor market conditions, actual inflation and inflation expectations have always been the key considerations in Fed's interest rate decisions.
The question now is: if that is so, why the Fed considered it necessary to say what the "Fed watchers" have known all along, i.e., policy actions will respond to changes in these key variables. I see a number of reasons for that.
Complicating the Guessing Game
First, the Fed is trying to anchor inflation expectations in order to keep long-term interest rates as low as possible for as long as possible — a task that will be increasingly difficult as the economy continues to strengthen in the months ahead. We have seen that already: in spite of its "Operation Twist," yields on a 10-year Treasury note have crept up more than 20 basis points since mid-November.
That is an unsettling development at a time when the economy continues to grow well below its noninflationary potential. The 10-year Treasury note is a benchmark for credit costs affecting consumer spending, housing demand and business investments – about 82 percent of the U.S. economy.
Second, announcing a specific unemployment rate (6.5 percent) as the main trigger for policy change is a clever move. Indeed, since labor market conditions are a lagging business cycle indicator, the Fed will have more time to let the upswing take hold before initiating the next phase of credit restraint.
Third, indicating an array of economic data to drive interest rate decisions will complicate markets' guessing about what — and when — the Fed might do to change its policy stance. Especially since the Fed also said that its decisions would be influenced by data other than labor market conditions and price stability. All that may give the Fed more time to pursue a course of action before markets absorb the new information and adjust investment positions accordingly.
Fourth, a prolonged period of easy credit conditions is needed to offset the depressive impact of tightening fiscal policies. "Fiscal cliff" and budget sequestrations (automatic spending cuts) are possible fiscal outcomes. But, whatever happens, higher taxes and declining government outlays are inevitable to reduce budget deficits, and to stop and reverse the growth of public debt.
Impaired Policy Transmission
As I wrote in an earlier post (After the Fed's "Twist" Comes a Hard Turn), the Fed is trying to guide the economy from a crisis-ridden lackluster recovery to a path of stable and sustained growth while its policy impact is still hindered by problems in credit channels.
For example, banks' excess reserves (the money banks can lend) in early December stood at $1.4 trillion, a huge increase from pre-crisis monthly averages of $1.5 billion to $2 billion. In spite of that enormous mass of loanable funds, the latest data for banks' consumer lending show an annual increase of only 2 percent. And the Fed is reporting that borrowers' access to a wide range of credit facilities is severely constrained by overly strict lending conditions.
There are two problems here. Banks are rebuilding their capital base by lending money to the government, and the banks' borrowing from the Fed's discount window shows that the U.S. financial system is still convalescing from a disastrous financial crisis.
Banks normally accumulate large holdings of default-free Treasury securities during recession recoveries because they have to clean up the bad loans and strengthen their balance sheets. The shorter and the shallower the recession, the shorter the period during which banks keep buying bonds before going back to their core business of consumer and business finance.
The fact that banks are still using most of the liquidity supplied by the Fed to buy Treasury securities rather than lend to the private sector indicates the extent of damage they suffered during the Great Recession.
And the damage is still there: banks' borrowed reserves (the funds banks obtain from the Fed's discount window) in early December were nearly $1 billion — a five-fold increase from the pre-crisis monthly averages of $150-$200 million. Clearly, the Fed continues to do some distress lending to stabilize the financial system, even though the current situation is an enormous improvement compared with $700 billion the Fed was supplying to prop up the failing banking system at the height of the financial crisis in November 2008.
Time Needed to Unclog Credit Channels
All this shows that credit markets are not working properly because most of the Fed's aggressive monetary stimulation is not reaching businesses and households. At some point, the process of financial intermediation will be fully reinstated, but that will only happen after the banks rebuild their capital base, and after they further reduce the recourse to the Fed as a lender of last resort.
We are approaching that point, but the banks' weak consumer lending indicates that it may still be months (not years) before we begin to see a strengthening impact of monetary policy on household consumption and business investments.
Investors should keep in mind the problems posed by financial system's post-recession adjustments before falling for vacuous arguments that monetary policy is ineffective. There is no "pushing on the string" or "liquidity trap" here. It is just a matter of time until the recovering banks are able to go back to finance consumer and business spending. That is now taking longer than usual because of the severity and duration of the financial crisis.
Watch the Fed's Money Market Operations
Of all the central banks around the world I have been following, the Fed is by far the easiest one to monitor. It provides a large number of data on its operations and credit market conditions on a daily, weekly and monthly basis. There are also policy statements after each of eight annual meetings of the Fed's rate-setting committee (FOMC) and detailed semi-annual congressional testimonies. No transparency problems here.
Investors interested in regularly updated information about labor markets, inflation and general business conditions can consult the Fed's "beige book" — a compendium of regional economic surveys serving as the main analytic input to FOMC meetings.
But if you want a shortcut to see how the Fed is actually reacting to data on employment, costs and prices, watch its daily money market operations and the pattern they form over a week or two.
That will give you plenty of advance warning about an incipient policy change. The Fed always carefully prepares its interest rate decisions in order to avoid excessive market fluctuations.
You can also watch this post.
Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.