Fed maintains target rate, will keep balance sheet size. Hoening dissents

The Federal Open Market Committee maintained its 0% to 1/4% target range for the federal funds rate today. The Fed repeated that “economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

In addition, the Fed announced that it will keep constant its holdings of securities by reinvesting Agency MBS and GSE debt principal payments into longer-term Treasuries.

Kansas City Fed President Hoenig dissented against both the extended period language and the decision to reinvest debt paydowns.

On the economy, the Fed said “the pace of recovery in output and employment has slowed in recent months” (the June statement noted “the economic recovery is proceeding”).

BOTTOM LINE

We are disappointed that the Fed took this small step to maintain the size of its balance sheet rather than allowing it to gradually decline as a result of paydowns of MBS and Agency debt. We do not see how preventing the Fed’s balance sheet from shrinking modestly from $2.3 trillion to $2.2 trillion will have any appreciable impact on the economy. However, it does signal that the Fed is concerned about the recovery and, therefore, expectations will likely grow for additional quantitative easing. This move has a bit of a feeling of panic by the Fed and probably reflects the impact that the Phillips Curve has on the Fed’s thinking about potential deflation risks. We ask the question: If the Fed is unwilling to allow the balance sheet to run off by around 5% over the next year, how long will it be before they will be willing to take the first step to hike rates? We currently view September 2011 as the first date for a rate hike but the risks are growing that it could be significantly later than that date. We expect this policy step to be bearish for the dollar and bullish for gold prices. As for Treasuries, we note that the Fed’s announcement in early 2009 that it would buy $300 billion of Treasuries had only a very temporary effect on depressing yields. One other thing—the whole episode had the feel of the Greenspan Fed because last week’s article in The Wall Street Journal (Fed Mulls Symbolic Shift, August 3) was clearly a leak.

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New York Fed's note on reinvested paydowns

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