Monday, 28 September 2009

Fed funds rate to stay exceptionally low

The on-going stabilisation in the United States economy and financial markets has allowed the Federal Reserve to remove some of the programmes it had implemented to ease financial conditions during the crisis but it is unlikely to raise interest rates soon.

On 23 September, the Federal Open Market Committee decided at its meeting to maintain the target range for the federal funds rate at zero to 0.25 percent. In its statement released after the meeting, the FOMC noted that "economic activity has picked up" and conditions in financial markets "have improved".

Nevertheless, the FOMC also indicated that a shift from the current accommodative monetary policy stance will be gradual. It said that "economic activity is likely to remain weak for a time" and this warrants "exceptionally low levels of the federal funds rate for an extended period".

However, the purchase of securities aimed at supporting credit markets will be wound down. The FOMC said that the Federal Reserve’s purchases of $300 billion of Treasury securities will be completed by the end of October 2009 while the purchase of $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt will be executed by the end of the first quarter of 2010.

In the light of better economic reports in recent weeks, especially the Conference Board's report on 21 September that its leading economic index for the US increased 0.6 percent in August -- its fifth consecutive month of increase -- the FOMC's decision to gradually end these unconventional programmes is not unexpected.

This is especially since even without these purchases, as long as the federal funds rate stays near zero, monetary policy will probably remain accommodative. The spread between the 10-year Treasury yield and the federal funds rate is now -- and has been for much of this year -- at a level that, in prior economic downturns, had usually presaged strong recoveries.

Indeed, actions by US policymakers on the whole, both in the Federal Reserve and the federal government, appear to have been quite successful in helping the real economy avoid develeraging thus far. According to the Federal Reserve's latest flow of funds report, total domestic nonfinancial debt increased steadily every quarter over the past few quarters despite the financial crisis.

Little surprise then perhaps that deflation in consumer prices appears to have been kept at bay. The main measures of inflation monitored by the Cleveland Federal Reserve all show that prices have not fallen for the past few months.

 Percent change from previous month
CPI less food and energy0.
16% trimmed-mean CPI0.
Median CPI0.
 Percent change, past 12 months
CPI less food and energy1.
16% trimmed-mean CPI2.
Median CPI2.

However, while the Federal Reserve is terminating its securities purchase programmes in the face of a recovering economy and diminished deflationary pressure, it is unlikely soon to take the next logical tightening step, that is, raising the federal funds rate. The damage done to the economy during the recession thus far has been to such an extent that there is, in the words of the FOMC, "substantial resource slack". This is expected to dampen cost pressures.

Historically, during economic recoveries, the Federal Reserve does not raise interest rates until measures of resource utilisation such as industrial capacity utilisation and unemployment show clear improvement trends.

So expect the Federal Reserve to leave the federal funds rate unchanged for many more months to come.

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