(Revised) Fed Keeps Steady Policy Course

In the past months, the Federal Reserve has executed a steady tapering in their purchases of  long-term treasury bill and mortgage backed securities, although not without opponents.  As expected, the Fed voted in January to reduce the QE scheme from $75 billion to $65 billion in purchases, in the midst of slumping developing markets, and the exchange rates of many foreign currencies fell in response to changing expectations in the domestic market.  As U.S. investors saw potential for higher U.S. returns as government demand for T-bills decreased, they pulled funds out of foreign markets, causing net capital outflows and the weakened currencies in those markets.

By continuing with the intended tapering policy, the Fed made a decision not to consider the potential adverse effects of their decision on foreign markets.  In fact, “Fed officials made no mention of these trends in the statement released [in January].”  In recent years, this has been the general strategy of the Fed, with chairman Ben Bernanke stating in 2011, “It’s really up to emerging markets to find appropriate tools to balance their own growth.”  Foreign central banks took this policy to heart in January, with the Turkish central bank raising it’s overnight lending rate over 400 basis points , and other small central banks enacting similar policies.  While their policies weren’t very effective, these emerging markets clearly understand that the U.S. will not shape their policy to accommodate them.

At the March FOMC meeting, the Fed stuck to it’s stated plan, further tapering purchases from $65 billion to $55 billion in the coming months.  Perhaps the key feature of the March statement was the change in language about when the federal funds rate would start to rise.  No longer was the the federal funds rate to float between 0 and 25 basis points, “at least as long as the unemployment rate remains above 6-1/2 percent” as in the January press release. Instead, the March statement stated rates will remain low, “for a considerable time after the asset purchase program ends”.

 

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This key feature highlights the Feds respect and compliance with their dual mandate to both keep inflation and employment at their natural levels.  The March statement cuts the tie between unemployment and the federal funds rate.  As Chairwomen Yellen has mentioned recently, the labor market is still weak, and has much room to improve despite the increase in employment.  The graphic illustrates how unemployment has dropped, but along with it labor force participation as well.  These facts, coupled with the increase in workers only able to find part time employment skew the actual health of the economy, and thus why the Fed has stepped away from using unemployment as a measure for the economy as a whole.

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Although the Fed has seemingly deviated from past statements, the policy actions are consistent with their overall mandates.  The Fed initially chose a 6.5% unemployment number to try and avoid overheating the economy and driving inflation up.  However, this is no concern, because inflation has actually been far lower than desired in recent years, hovering between one and one and a half percent, despite the influx of money into the economy by way of the present quantitative easing.

I believe that the Fed has made the correct decision not to react to the fluctuations in the foreign markets or faulty economic data in their recent policy decisions. The Fed has recently show discipline not to venture from solid fundamentals and also to be willing to adjust expectations to what is best for the economy.  Although unheralded, the Fed has been key in propelling the economy towards recovery and stability, and has probably save tens or hundreds of thousands of jobs.