From: Gregory S. MacKay, Senior Vice President & Chief Economist
“Less Gas, No Brakes”
One of the goals Chairman Ben Bernanke had when he became the Chairman of the Federal Reserve Bank was to make the movements of the Fed more transparent, so that markets would properly interpret Fed policy moves. Press releases after FOMC meetings during his terms have become more “plain language”, and have been easier to understand. To further aid this goal, the Chairman added a press conference after the release to some meetings beginning in late 2011, as the complexities of Quantitative Easing begged more explanations.
Hence, the press release of the June 18-19 FOMC meeting created much less fanfare that the subsequent press conference. The press release was more positive than last month, saying that the Committee “sees downside risks to the outlook for the economy and the labor market as having diminished” (underlining ours). Digging into the numbers, Fed members are predicting faster GDP growth, lower unemployment, and lower inflation than in their March 2013 projections.
In his press conference remarks, the Chairman explained again that the current program has two tools: hold the Federal Funds rate at low levels, and provide more “accommodation” (stimulus) through the purchase of Treasury and Mortgage Backed Securities.
Recent press releases have stated targets of a 6½% unemployment rate and a 2% inflation rate as indications of when Fed policy might change. (For most of my readers, that would mean higher CD and mortgage rates.) Chairman Bernanke went to great lengths in this press conference to explain the differences between the applications of these tools.
First, the Federal Funds rate is seen by him as the “brakes on a car”. Movements in the Federal Funds rate have a very immediate effect on short term money rates, and generally telegraph Fed policy intentions. The Chairman said that no changes “will be appropriate” in the Federal Funds rate until the unemployment rate reaches 6½%. Thus, for now, “no brakes” will be applied to the economic car.
Secondly, the Chairman sees the monthly purchases of $85 billion of securities as “pressing down on the gas pedal” of the economic car. This somewhat unusual tool has been in use since November 2008, and has helped keep mortgage rates abnormally low for some time. Low mortgage rates, improving home prices and demand, a better stock market, stronger consumer confidence, and more jobs are all intertwined to create a stronger economy. In this week’s press conference, Chairman Bernanke indicated an adjustment in policy, separating bond purchases from Federal Funds activity. Recognizing that these bond purchases have helped the economy recover, and if there are “continuing gains in the labor markets…moderate growth that picks up over the next several quarters… near term restraint from fiscal policy diminishes”, then “it would be appropriate to moderate the monthly pace of (bond) purchases later this year… ending purchases around mid-year (2014)”, suggesting that bond purchases would end when the unemployment rate was in the vicinity of 7%. He did go to great lengths to say that this was an “easing up on the gas pedal”. If economic conditions continue to improve, the purchase of bonds by the Fed will slowly diminish, but the current plan of reinvestment of interest and maturing issues will not change. Thus the confusion and speculation of the last few months has been clearly answered. These two policy tools are not linked, and are subject to different rate levels. Moreover, Chairman Bernanke stated several times during the press conference that the 6½% and 7% levels were “thresholds”, and not absolute triggers or targets, making a point that this entire process of Quantitative Easing is subject to constant review and revision.
Both stock and bond market traders reacted like kids whose ice cream fell out of their cones. Stock indices nose dived for two straight days, and are weak today. Five, ten and thirty year Treasury yields rose .30% overnight, and are up about ½% since just before the May FOMC meeting. The longer (10 years+) bond yield increases make sense, reflecting an after inflation yield moving back toward normalcy. Stock prices should recover when the short term “what about me?” mentality is overridden by the fact that the Chairman and other members of the Fed believe the economy is approaching a self-sustaining expansion. “Less gas, no brakes”, in the long run, is really good news. At 12:15 p.m., for the week and year:
Bond buyers can be happy that yields are improving, but everything from zero to a five year maturity still does not reflect a real yield above inflation.