At its meeting today, the Federal Open Market Committee (FOMC) decided . . . , well, decided not to decide. Faced with a feeble US economic recovery showing clear signs of getting weaker still, and a perilous economic situation in Europe poised to spin out of control into a full-blown financial crisis, the FOMC opted to continue the status quo, prolonging its so-called Operation Twist in which the Fed is liquidating its holdings of short-dated Treasuries and replacing them with longer-dated Treasuries, on the theory that changing the maturity structure of the Fed’s balance sheet will reduce long-term interest rates, thereby providing some further incentive for long-term borrowing, as if the problem holding back a recovery were long-term nominal interest rates that are not low enough.
What I found most interesting in today’s statement was the FOMC’s assessment of inflation. In the opening paragraph of its statement, the FOMC states:
Inflation has declined, mainly reflecting lower prices of crude oil and gasoline, and longer-term inflation expectations have remained stable.
What is the basis for the FOMC’s statement that inflation expectations are stable? Does the FOMC not take seriously the estimate of inflation expectations just published by the Cleveland Fed showing that inflation expectations over a 10-year time horizon are at an all-time low of 1.19% and the expectation for the next 12 months is 0.6%, the lowest since March 2009 when the stock market reached its post-crisis low? And the FOMC’s April projection for PCE inflation in 2012 was in a range 1.9 to 2.0%; its current projection is now 1.2 to 1.7%. In contrast to 2008, when the FOMC was in a tizzy about inflation expectations becoming unanchored because of rapidly rising food and energy prices, the FOMC seems remarkably calm and unperturbed about a 0.3% fall in headline inflation in May.
Then in the next paragraph the FOMC makes another — shall we say, puzzling — statement:
The Committee anticipates that inflation over the medium term will run at or below the rate that it judges most consistent with its dual mandate.
So the FOMC admits that inflation is likely to be less than its own inflation target. Let’s be sure that we understand this. The economy is weakening, growth is slowing, unemployment, after nearly four years above 8 percent, is once again rising, and the Fed’s own expectation of the inflation rate for 2012 is well below the FOMC target. And what is the FOMC response? Steady as you go.
In a news story about the FOMC decision, Marketwatch reporter Steve Goldstein writes:
The Federal Reserve on Wednesday softened its growth and inflation forecasts over the next three years, as the central bank said the unemployment rate will hold above 8% through the end of 2012. The Fed also cut its inflation forecast down aggressively, to between 1.2% and 1.7% this year, as opposed to its forecast in April between 1.9% and 2%. The central bank targets 2% inflation over the medium term, so the reduced inflation forecast is likely to ratchet up expectations of additional central bank easing, possibly as soon as August. The Fed’s forecast for growth this year is down to a range of 1.9% to 2.4%, down from 2.4% to 2.9% in April — and its April 2011 forecast that 2012 growth would range between 3.5% and 4.2%. Also of note, it appears that the two newest voters, Jerome Powell and Jeremy Stein, are among the most dovish; the most recent breakdown of when the right time to raise hikes shows the only change is in 2015, which now has six members in that camp, up from four in April. Powell and Stein were recently sworn in as Fed governors.
So the optimistic take on all this is that the FOMC has set the stage for taking aggressive action at its next meeting. Since bottoming out last week, stock prices recovered, apparently in expectation of easing by the Fed. Today’s announcement is not what the market was hoping for, but there are at least signs that the FOMC will take action soon. In our desperation, we have been reduced to grasping at straws.
Uneasy Money 
The forecast inflation rate is well below the target, unemployment is going to stay high the rest of the year, and the Fed’s prescription is: steady as she goes! Maybe cratering inflation expectations is a bad sign?!? Maybe it shows that increasing robust action by the Fed would be called for! FOMC says, “We want to act the part of Nero. Get the sandbags ready, Rome is about to start flooding. The fire will be quenched by the rising water level!” This is really really REALLY sick!!!
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Your post inspired me…
Here is my latest post “FOMC: ditch the sandbags, grab the buckets.”
http://socialmacro.blogspot.com/2012/06/fomc-ditch-sandbags-grab-buckets.html
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Great post – very helpful. I’ll be reading it to my husband over the breakfast table.
This is a miserable, miserable situation.
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Really enjoyed your post yesterday on the non-neutrality of money (inspired post here http://bit.ly/LDyFvA) although I have to slightly disagree with your assessment here. The points about declining inflation and growth expectations are good, but I think the extension of Operation Twist implies the Fed won’t act on more QE until after the election (http://bit.ly/N9GLe9).
Do you think the Fed will run both programs at once or will cease with Operation Twist coinciding with the start of QE? Separately, though there is no strong basis for this reasoning, this Fed appears more concerned with expectations stemming from the stock market. From that perspective they could argue that inflation and growth expectations remain at a reasonable level (I don’t agree with this view but it crossed my mind.)
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The meaning of “stable” is quite clear, actually–“…inflation over the medium term will run at or below the rate that it judges most consistent with its dual mandate…” So long as (expected) inflation is at or below 2%, then (expectd) inflation is stable. If it exceeds 2%, then it is not stable.
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The Fed doesn’t seem to understand that even if long-term inflation expectations were in fact stable, it would be entirely based on an expectation on the market’s part that the Fed would intervene when short-term inflation expectations fell below target. In other words, the long-term expectations are dependent on the Fed adhering to its target, not ignoring it.
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honestly, i do not take that cleveland fed model too seriously. Its a fancy way of estimating the term premium and backing it out. The model error is pretty high, even for more current tenors like 2 and 3 year. The trend is more important – but for that we can just look at TIPS-implied breakevens, the 10 YR BE are at 2.07%.
the real fun begins when the 1 yr BE goes negative:
http://www.bloomberg.com/quote/USGGBE01:IND/chart
But any deflation will be short lived (thank god for that!)
http://www.bloomberg.com/quote/USGGBE02:IND/chart
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The Fed has become a perverted palace, in which subalterns and a demented caste worship price stability before economic growth.
Set aide that even measuring price stability has become an art in a world a rapidly evolving goods and services. Forget that the USA prospered through moderate inflation in 1982 through 2008.
What matters is that we genuflect to price stability.
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If interest rates rise due to either higher inflation or better economic growth (or both), then the Fed’s longer maturity holdings would not be able to be sold back at par. This means they either leave the extra cash out in the system until maturity or sell anyway and leave some of the extra cash out in the system. Either way, doesn’t Twist essentially tell the markets that the Fed will not be able to drain cash back out as quickly as if they kept maturities shorter?
Of course as long as they are sitting on a ton of short term maturities, they can still drain a lot of money out quickly so Twist may not really help unless on a much bigger scale.
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Kicking the can down the road is exactly the right statement, for the sort of action that we see happening over at the FED.
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Julian, The Fed as Nero; interesting idea. Does Bernanke or anyone else on the FOMC own a horse? Glad to hear that I provided some inspiration.
Catherine, Hope it made for good reading. You must get a lot done at breakfast.
bubblesandbusts, Not sure what you mean about the Fed being concerned with expectations stemming from the stock market. In its statements about monetary policy, the Fed usually refers to expectations of inflation as an indicator of whether it needs to change monetary policy.
Donald, There seems to be something in the psychological makeup of central bankers that views inflation below the target as being a good thing while inflation above target is a bad thing. I really think that the Fed was really pleased with itself in August and September 2008 when the dollar was soaring in FX markets, viewing the appreciation as evidence that it was conducting monetary policy splendidly.
david, Excellent point.
dwb, Well, I am not sure how seriously to take their model, but I find it odd that the FOMC makes no reference to it at all. I also agree that the important thing is the trend in inflation expectations which is clearly negative.
Benjamin, We are getting some pretty wild comparisons here. The Fed is driving us all to distraction.
Bill, The Fed is not supposed to worry about its own balance sheet. All its profits go back to the Treasury anyway. A recovery would generate more net revenue for the consolidated Treasury/Fed balance sheet than the losses on sales of longer term maturities. But I agree that operation twise is accomplishing very little.
Tas, Glad that you agree.
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