On August 1st the Fed announced no new initiatives (besides what it had already announced in the prior meeting, e.g Operation Twist extension), while making it clear that it stood ready to provide more stimulus if needed. We got some insights, via the Fed meeting minutes, about the FOMC's mindset, which brought that decision.
'High Level Of Uncertainty'
The discussions addressed the weakening in economic conditions and the tone was generally more dovish than at the prior meeting. In light of the string of weak data leading to the rate-setting meeting, several members lowered their expectations for economic growth over the coming quarters. There was "an unusually high level of uncertainty" to members' assessments of the economic outlook (who can blame them, given the massive question marks about Europe and the upcoming US fiscal drag?). Members viewed risks to economic growth as tilted to the downside, but refrained from providing more stimulus just yet because "more time was seen as necessary to evaluate the effects" of stimulus provided at the previous meeting (i.e extension of Operation Twist). Secondly, members, while expressing support for extending the forward guidance, agreed to defer the decision until September to coincide with updated Fed economic projections.
Members suggested that "additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery".
Stimulus Tools Discussed:
- Extension of the period over which the Committee expects to maintain its target range. Members think that this may be "particularly effective" if done together with a statement that monetary policy will remain highly accommodative even if the recovery progressed.
- A new asset purchase program (i.e. QE3). The Fed's staff addressed previously raised concerns by stating that there was "substantial capacity for additional purchases without disrupting market functioning". Members thought that such a program should be sufficiently flexible if dispatched, to respond to economic developments.
- Reduce interest rates paid on reserves at the Fed. That tool, however, raised concerns among "several members" given the potential negative impacts on money markets.
- Funding for lending.
The minutes clearly show an easing bias from FOMC members. In our view, the timeline for interest rates to remain at zero could be extended to beyond 2014, as early as next month's FOMC meeting depending on the sequence of the next economic numbers (including the August non-farm payrolls, ISM data, and Eurozone data and politics…Germany Constitutional Court rules on the ESM). Asset purchases also remain an option, more so given that the Fed now has research that shows substantial capacity for additional asset purchases without disrupting market functioning. The Fed seems to be comfortable with another round of reflation to prop up risk assets and cheapen the USD.
How large a QE3 program, if any, will also depend on any action from Congress. The fiscal drag remains a point of massive uncertainty. Interestingly, the Congressional Budget Office (CBO) released this week its update to the budget and economic outlook. The CBO noted the considerable uncertainty around its current baseline forecast given the substantial changes to tax and spending policies that are scheduled to take effect in January 2013. At this juncture, the CBO assumes a relatively small fiscal drag of $97 billion in 2013 under a scenario where current tax holidays generally remain in place. Under the alternative scenario where such measures are not extended, a fiscal drag of roughly $500 billion would send the economy into recession (contraction of -0.5%). That explains in large part "an unusually high level of uncertainty" to FOMC members' assessments.