Fed Tries to Stimulate the Economy With Its Words

Central bankers expressed concern with the economy's direction, but chose not to provide any monetary stimulus at this time

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Perhaps the pen is also mightier than the dollar. In its last meeting of the summer, the Federal Reserve announced that it would not aid the struggling U.S. economy with additional monetary stimulus. Instead, it revised its meeting statement's language to indicate that interest rates would remain near zero through mid-2013. Its decision to better define the length of its extraordinary interest rate policy provides certainty that the markets might embrace, but will it be enough to push the economy back towards recovery?

The Big News: "QE 2.1"

Let's start with the key sentence from the Fed statement:

The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

This is a fairly unusual move by the Fed, and marks the use of yet another tool to try to keep the market content. Analysts may refer to this as "QE 2.1," indicating its small but significant effort to assuage the market without any additional monetary support. Wall Street now knows that interest rates will be exceptionally low for approximately two more years. This will alleviate any fears that the Fed could begin to raise rates before then.

Not all members of the Fed's monetary policy committee were on board with this language change. Three members -- Richard W. Fisher (Dallas Fed President), Narayana Kocherlakota (Minneapolis Fed President), and Charles I. Plosser (Philadelphia Fed President), all wanted to leave the old language intact.

That's some serious dissent from a committee that usually acts in unison, or near-unison. It also indicates that additional monetary stimulus probably never had a shot. If these three members weren't even on board with something as comparably benign as altering the meeting statement's language about policy, then it's hard to see how there could have been near-sufficient support to inject additional money into the financial system.

The Fed's second round of stimulus ended in June. At that time, the Fed signaled that additional monetary stimulus should not be expected. Still, the Fed's decision to stay the course will disappoint Wall Street. Some investors and economists had expected that news had turned ugly enough to warrant additional action by the Fed.

The statement did, however, say that the committee discussed other tools in its arsenal that it could use if the economy continues to worsen. So other efforts were definitely discussed, we just don't know what precise strategies the Fed might take in order to provide additional support in coming months if the economy worsens. But if the U.S. economy is going to improve through the end of the summer, it'll have to do it without the Fed. Its next meeting isn't until late September.

A More Pessimistic Fed

Although the meeting minutes will give us a better idea of more precisely how Fed economists feel about the direction of the U.S. economy, the statement is revealing enough. Here are a few highlights of ways in which we saw the Fed's tone turn gloomy (strike-through represents language from the June statement with the August language in italics):

  • economic growth is continuing at a moderate pace, though somewhat more slowly has been considerably slower than the Committee had expected
  • recent labor market indicators have been weaker than anticipated suggest a deterioration
  • Household spending continues to expand has flattened out

Some of its other June assessments are unchanged: the housing market is still weak, and businesses investment continues to expand. It also still sees longer-term inflation expectations remaining stable, though inflation has declined in recent months.

We'll have to watch to see how the market interprets this move from the Fed. After the statement was released, the Dow Jones Industrial Average turned negative, erasing earlier gains. Obviously, the labor market is no where near healthy, so it might benefit from additional monetary support. This implies that the central bank must be deeply concerned that additional asset purchases could cause overstimulation and excess inflation. Unless inflationary fears changes, the Fed might refuse to inject additional money into the financial system.

Image Credit: Mark Dye/Reuters