Cross-posted from Credit Writedowns
Today, the Federal Reserve told us that interest rates will remain at zero percent for two more years, making official the policy I have dubbed permanent zero. In response we saw a massive rally in treasuries starting at about 225PM ET and equities starting at about 240PM ET as interest rate expectations ratcheted down. The Ten-year is at 2.18 and the Dow rallied 430 points.
Permanent zero is what many market participants expected. On Sunday I wrote about the chatter saying:
- For the Fed, first it will be explicit ‘permanent zero’ policy, then they will try cap short end rates, followed by longer-rate caps #QE3 $$
- Watch the increasing chatter around ‘permanent zero’ and interest rate guarantees. This will presage Fed policy change. Won’t be called #QE3
Here’s what the FOMC said (I have underlined the most important parts):
Information received since the Federal Open Market Committee met in June indicates that economic growth so far this year has been considerably slower than the Committee had expected. Indicators suggest a deterioration in overall labor market conditions in recent months, and the unemployment rate has moved up. Household spending has flattened out, investment in nonresidential structures is still weak, and the housing sector remains depressed. However, business investment in equipment and software continues to expand. Temporary factors, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan, appear to account for only some of the recent weakness in economic activity. Inflation picked up earlier in the year, mainly reflecting higher prices for some commodities and imported goods, as well as the supply chain disruptions. More recently, inflation has moderated as prices of energy and some commodities have declined from their earlier peaks. Longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting and anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, downside risks to the economic outlook have increased. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate as the effects of past energy and other commodity price increases dissipate further. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.
To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent. The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.
The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen.
Voting against the action were: Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, who would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an extended period.
Three members voted against here. Two months ago I said political concerns meant the Fed would probably not go full QE until 2012 and that the first move toward rate easing and QE3 would be permanent zero:
My understanding about what [Pimco’s Bill] Gross believes is that the Fed could see QE3 "guaranteeing" a 2 year or 3 year yield at a certain level—say 50 basis points. Moreover, the Fed would not necessarily have to buy any Treasuries to defend this target. Gross understands that the private sector “would do it” for the Fed via the language and confidence in the "guarantee"…
My sense is that this will not be called quantitative easing or credit easing or anything like that. Those terms are dead because they are now politically radioactive. But operationally, the policy will be the same. This time the Fed will target price instead of quantity.
P.S. – The Fed is likely to soft peddle this policy change because of comments from people like former Atlanta Fed President William Ford questioning Can the Fed Go Bankrupt? The Fed will want to stay to the shorter end so as not to risk its balance sheet by moving out the curve with interest rate caps. However, there could be internal dissent, so the Fed could start off by signalling to the market that it will conduct what I have been calling ‘permanent zero’. Eventually people will be forced to accept this – and the term structure will flatten further and further out the curve. That’s how Japan got to a 1% 10-year yield because expectations of zero rate policy continued to lengthen in time.
Again, politically the Fed is constrained. But, my call on 2012 is starting to look wrong because the global economic environment is weakening quickly. If the economy deteriorates further, expect the timetable to speed up.
I believe this is the first salvo in a renewed easing campaign by the Fed. Right now everyone is acting like this isn’t QE. But I told you two months ago that it is.