Fed Maintains Dovish Tone

The U.S. Federal Reserve kept the fed funds rate unchanged at zero and its statement was little changed. It re-emphasized the thresholds for the unemployment rate (6.5%) and the inflation rate (2.5%) that would need to be attained before it would consider raising interest rates. The Fed will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The FOMC also maintained its policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities. Supporting its decision, the Fed said that it still sees downside risks to the economic outlook. Inflation has also been running below the FOMC's longer-run objective. As usual, there was one dissenter. Jeff Lacker is no longer on the FOMC but the dissenting view came from Esther George who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances.

Bottom Line
The Fed stuck to its dovish tone in today's statement. The FOMC managed to navigate through the unease shown by some members about QE3 as per last December's minutes, and the asset purchase program was reaffirmed. The dovish tone isn't surprising given that we're still miles away from the stated thresholds for the jobless and inflation rates. Moreover, the economy is not performing as the Fed had expected just last December when it updated its projections. Based on the advance Q4 GDP report, the US economy grew a paltry 1.5% in 2012 (Q4/Q4), i.e. below the Fed's central tendency forecast of 1.7-1.8%. That said, the GDP contraction in Q4 doesn't mean that the Fed's asset purchase program should be expanded because the FOMC attributes a large part of the softness to temporary factors including weather impacts.

We continue to expect the Fed to keep rates at zero until at least 2015, given that the 6.5% threshold for the unemployment rate is unlikely to be met over the next couple of years, particularly if, as we expect, the participation rate rises. In any case, low rates will be needed to counter the fiscal drag which is set to weigh on the U.S. economy for the next few years as tax hikes and at least some of the sequester cuts come due. As for the asset purchase program, there is nothing in this press release to make us change our view about a potential wind-down later this year as growth picks up.