FOMC

As the market awaits the Federal Reserve’s statements on Wednesday, the focus is on whether the FOMC will choose to signal a significant shift in a hawkish direction since its last meeting in July. Many investors believe that the key litmus test for this will be whether it chooses to drop two words from its July statement.

These words are “considerable time”. If that phrase disappears, then the market will need to absorb the fact that the Fed has deliberately chosen to force an upward adjustment in forward interest rate expectations, for the first time in this economic cycle. 

The Federal Open Market Committee of the Federal Reserve is no longer expected to announce a further round of monetary easing when it concludes its two day meeting in Washington on Wednesday. The fact that the hawks have lost enthusiasm for more quantitative easing is scarcely surprising, given the fall in unemployment, and the stickiness of inflation.

But until very recently the hawks have not been in control of the committee. What is more surprising is that the powerful group of doves which includes Ben Bernanke, Bill Dudley and Janet Yellen, and which normally has disproportionate weight on the FOMC, has also taken QE off the agenda .

 

Opinion is sharply divided about what the Fed intended to signal in the statement issued on Tuesday. Some have seen the statement as very dovish, because it said that the Fed intended to leave short rates at “exceptionally low levels” until mid 2013 – the first time that a specific date of this sort has ever been set by the FOMC.

Others, however, concluded that the statement contained nothing really new, since the markets had already assumed that short rates would be close to zero for the next two years. Furthermore, the fact that there were three dissents from the majority decision has led some to deduce that the further large step to more quantitative easing (QE3) is still a long way off. On this view, nothing really changed. 

Ben Bernanke

Ben Bernanke. Image by EPA.

The financial markets seem determined to interpret today’s statement by the Fed chairman in a dovish light, but a careful reading of his words does not support that point of view. True, Mr Bernanke outlined the possible ways in which monetary policy might be eased further if recent economic weakness should prove more persistent than expected. But he gave equal weight to the possibility that “the economy could evolve in a way that would warrant less-accommodative policy”.

There was no hint in the text about which of these outcomes he considered the more likely. We already knew from yesterday’s FOMC minutes for the June meeting that the committee is split about the likely evolution of policy, and we were waiting to see today whether the chairman would throw his weight behind either the doves or the hawks. He failed to do either. 

The ongoing discussions in Washington about the US public debt ceiling are raising some interesting ideas, some of which are highly unorthodox. One such idea is that the debt ceiling itself can simply be ignored because any attempt by Congress to restrict the ability of the United States to meet its debts appears, on the surface, to contravene section four of Amendment XIV of the Constitution.

This Amendment states that “The validity of the public debt…shall not be questioned.” I will leave this matter for debate among constitutional lawyers (see here and here), but as a simple economist I would question whether the US would retain its triple A status if the administration continued to make payments in contravention of an explicit act of Congress, which the President believed to be unconstitutional. What would happen to the “full faith and credit” of the United States if the Supreme Court subsequently ruled that the President was wrong? 

William Dudley, the President of the New York Fed, is an intellectual heavyweight with whom I was fortunate enough to work for a couple of decades. Long experience has taught me not to ignore his views on the economy. He made an important speech last Friday,  spelling out the dovish view on monetary policy which is currently held by the most senior members of the FOMC, probably including Ben Bernanke.

Although the speech was careful to go no further than the statement which followed the last FOMC meeting in September, it explained in considerable detail why the Fed now believes that inflation is too low, and why he at least also believes that a further round of QE is the right response to the situation.