Fed reinvestment decision points policy wrong way

August 11, 2010

The Fed has pointed its policy the wrong way. Spooked by slowing growth, the Federal Open Market Committee decided to loosen money marginally at its latest meeting on Tuesday. This was done by agreeing to reinvest the runoff in the central bank’s agency and mortgage-backed securities portfolio into longer-term government debt.

However, weaker productivity has now joined rising global prices to add to U.S. inflationary pressure. The result is that the Fed has put itself in position to lag any economic shift.

The FOMC appears to have reacted to the slowing pace of recovery in output and employment. The small directional adjustment is more important than the policy itself. The Fed’s holdings of agency and mortgage-backed securities averaged $1.3 trillion in the week of Aug. 4, or just $40 billion more than in the week of March 31, when Fed purchases of such securities were supposed to have ended.  Overall, the Fed’s balance sheet increased over the same period by a mere $19 billion, to $2.3 trillion. Thus, a decision to strictly reinvest maturing securities will not significantly alter the balance sheet trend.

Though prices may be stagnant in the United States, they are not so everywhere. Global commodity and energy markets continue to exert upward pressure, with new highs in copper, tin and wheat. Moreover, the rapidly growing economies of China and India, where wages and prices are rising, seem likely to feed through to U.S. goods and services imports in coming months.

Add to that the latest quarterly U.S. productivity report. It suggests the rapid productivity growth during the recession has ceased. The trend may be good news for unemployed American workers, but it’s bad news for corporate profits, prices — or, very likely, both.

Thomas Hoenig rightly wanted to nudge the Fed in the other direction. The president of the regional Fed bank in Kansas City recommended the FOMC remove its “extended period” language for maintaining current ultra-low rates to give itself flexibility to tighten rapidly if it proves necessary. That would seem a wise precaution; the number of inflationary signs is outpacing the deflationary ones, and popping up fast enough that a swift and powerful Fed response could become necessary.


We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

Hoenig – you are absolutely right!

Posted by minipaws | Report as abusive

Looks like only one brain on the Fed. Continuing the low rate policy (ie pushing on a string) will accomplish just what it did in Japan – produce a long period of no growth. Interest rates should only be reduced when they are strangling the economy – ie reducing from 10% to 5% helps. This is because borrowers need money to grow business by having reasonable rates – and, lenders need to have a reasonable profit for lending. This usually means a rate of around 4-5%. By dropping rates to zero in one fell swoop all the Fed did was allow the bankers and swindlers to reap huge profits (and bonuses) at the taxpayers expense. The Fed also de-stimulated the economy by removing the interest income which would have been paid to bill/note/bond holders, many of which are retirees counting on this income (thus screwing them in order to pay-off the swindlers and bunglers on Wall Street). If we assume $5T in Treasuries held in the US and a drop of 2.5% in average rates, then a $125B was removed from the economy – thus de-stimulating it. Thanks loads Benji…!

Posted by Eric93 | Report as abusive