The Fed Becomes Indecisive

The stock and bond markets would like to be able to easily predict what the Federal Reserve will do for several months after each Federal Open Market Committee Meeting. If they had the knowledge it would take some risk out of trading. The Fed has been fairly predictable for the last year. Interest rates have been held near zero. The Fed has been actively buying US government paper and mortgage-related securities.

The united front among the Board of Governors began to fall apart at the FOMC meeting on December 15th and 16th. Those who attended the meeting agreed that residential real estate is recovering while commercial real estate values are still troubled. Industrial production is up, but manufacturing utilization is still low. The financial world and economy are getting better, even if the improvement is slow.

Some of the governors believe that the economic recovery cannot be sustained without support from the Fed and broader governmental policies. These participants in the meetings argued that the real estate market will be harmed if the Fed withdraws its purchases of mortgage-back securities. Concern about the expiration of tax credits for homebuyers was also voiced. In other words, the value of residential homes could take another sharp dive without artificial support.
The second issue that caused disagreement among members was how small businesses should get access to capital. “Participants again noted the contrast between large and small firms’ access to financing. Large firms that can issue debt in the markets appeared to have relatively little difficulty obtaining credit. In contrast, smaller firms, which tend to be more dependent on commercial banks for financing, reportedly faced substantial constraints in gaining access to credit,” the minutes said. The members were not able to produce any consensus on how this problem could be solved, but all agreed that it is a serious problem for the economy and an enemy of the recovery.

The third issue on which there was clearly debate among the members was inflation. That is odd because the economy seems too anemic to produce any sharp rise in demand for goods and services. But, several of the more clever experts at the meeting believe that a recovery in the general business environment could cause banks to begin aggressive lending which would push excess liquidity into the market.

All of this points to a Fed that has become at least partly divided. Some members think it is too early to withdraw support for banks and the mortgage markets.” Others feel that inflation risks were tilted to the upside, particularly in the medium term, because of the possibility that inflation expectations could rise as a result of the public’s concerns about extraordinary monetary policy stimulus and large federal budget deficits,” according to the Fed report. The FOMC minutes, thus, have both ambivalence and ambiguity written all over them.

The markets were shaken by a lack of clear direction from the Fed. Stocks rose after the FOMC minutes were released and then sold off shortly after that. It began to occur to traders that they could not count on a firm end date for Fed intervention in the housing and US debt markets and that a hint of inflation would cause the central bank to make rate hikes.

The most significant concern about the FOMC meeting early last month is that without a consensus among the members there cannot be any really clear direction from the agency. Fed Governors are unsure of what should happen as the economy recovers, mostly because this improvement is uneven.

In order to support one area of weakness in the economy, the delivery of capital to that sector could cause overstimulation in another part of the economy. Monetary policy is easier to set in a difficult recession, whether it works or not, because the only real goal is to avert a credit system collapse.

Now the Fed members have begun to argue in private, it is just a matter of weeks before they begin to be more vocal about their views in public. Members of the Supreme Court have a tradition of not discussing their deliberations or decisions in public. Fed Governors and presidents of the Federal Reserve regions have never believed in that sort of discretion.

The Fed Governors are confused for the first time since the recession reached an alarming level. And, that by itself is something new to be alarmed about.

Douglas A. McIntyre