Published: Wed, 28 Jan 2009 21:56:31 +0100

FOMC Keeps Rates Unchanged, Hints at Purchasing Treasuries

In terms of policy, the Jan. 28 statement wasn't so distinct from the Dec. 16 statement. William Poole, former Governor of the St. Louis Fed, said the changes were "pretty minor."

One addition was, "the Committee anticipates that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant."

In the December statement, the Federal Open Market Committee (FOMC) didn't offer an outlook for eventual recovery.

Another addition, which contributed to the unusually long length of the communiqué, was that the board members said the Fed is prepared to purchase longer-term Treasuries if it would be "particularly effective in improving conditions in private credit markets."

Market reactions to the statement were mixed: the U.S. dollar rallied after the release, while equities took very little direction, but broadly maintained gains from earlier in the session.

"I think there was an expectation of acceleration in quantitative easing," said Mark Frey, vice-president of FX trading at Custom House. He said he expects the U.S. dollar rally to run out of steam and for the EUR/USD to go back up near 1.33 USD.

Matthew Strauss, currency strategist at RBC Capital Markets, added, "It's clear that the Fed is prepared to do everything to help the U.S. through this crisis. That commitment has bolstered the U.S. dollar." However, he too said the rally would be short-lived.

On the prospects for growth, the Fed's economic outlook was dour, saying, "Industrial production, housing starts, and employment have continued to decline steeply, as consumers and businesses have cut back spending."

The Fed noted that government efforts appear to be improving financial markets, adding that it would continue to "employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability." The Fed pledged to keep interest rates at "exceptionally low levels" for some time.

Some analysts were expecting the central bank to expand its list of available tools to include an inflation target, but no such announcement was made.

On price stability, the Fed said falling energy prices should keep inflation pressures "subdued in coming quarters." Deflation wasn't explicitly mentioned in the statement, but the central bank hinted at such concerns when it said, "the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term."

Since early September, the Fed's balance sheet has grown over $1 trillion to more than $2.1 trillion in total, as it initiates new lending programs to stimulate the economy.

Going forward with these unconventional programs, the Fed said it would continue "to purchase large quantities of agency debt and mortgage-backed securities," adding that the Fed "stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant." 

Poole told Bloomberg TV he thought there was "some ambiguity" in the statement as to whether the central bank will continue to expand the balance sheet, or simply keep it at the current elevated level.

Senior U.S. economist Paul Ashworth from Capital Economics also criticized the Fed for being oblique. He called the statement "a wonderful example of how bad (the Fed's) communications can sometimes still be."

Markets are looking for clear guidance, and instead the Fed "offers a series of cryptic possibilities in a statement that nearly spills over onto a second page," he added.

However, Millan Mulraine, economist at TD Securities, said the FOMC was clear in expressing its intention to pursue more unconventional approaches.

"The Fed has now expressed its willingness to outright expand (the balance sheet)," he said. Going forward, Mulraine expects the Fed to announce such a policy when conditions warrant it.

The next key update on how the economy is performing will be Friday's release of fourth-quarter GDP.

By Patrick McGee, pmcgee@economicnews.ca, edited by Sarah Sussman, ssussman@economicnews.ca

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