Explaining the Stir over Recent “Fed-Speak”
by Robert Gahagan, Senior Vice President, Senior Portfolio Manager, American Century Investments
and John Eichel Investment Writer
March 20, 2012
The official statement from the Federal Reserve’s March 13 interest rate policy committee meeting was relatively ho-hum (no significant changes from January’s statement), but other recent Fed communications have raised more of a stir. In particular, we explain what “fiscal cliff” and “sterilized QE” mean, and help put them into context. It’s all part of a mixed, uncertain economic outlook in which slower mid-year growth, like last year, can’t be ruled out, but higher inflation by next year is also a possibility.
The U.S. Federal Reserve (“the Fed”—the U.S. central bank) announced no immediate significant changes or tweaks in U.S. monetary policy after its latest Fed Open Market Committee (FOMC) meeting on March 13. The Committee voted to keep the federal funds rate target for short-term interest rates at a historically low 0–0.25% (where it’s been since December 2008), continuing, as it did in January, to say that it “anticipates that economic conditions…are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”
The Committee also voted to continue “Operation Twist”-related selling of short-term U.S. Treasury securities and purchases of long-term Treasury securities. This strategy is intended to rebalance and refocus the Fed’s balance sheet toward longer maturities, designed to help keep long-term interest rates (such as home mortgage rates) low (see “Our Take on the Fed’s 50-Year Anniversary Revival of ‘Operation Twist,’” American Century Investments Blog, posted September 26, 2011).
Swirling Speculation about Inflation Risks
But the lack of change in the Fed’s last policy statement doesn’t mean that all is quiet and calm at the central bank. Despite the mostly status-quo nature of the statement, speculation has been swirling in the background among economists and other market participants and observers (and, reportedly within the Fed itself) regarding the Fed’s next policy moves or announcements.
Much of the speculation has centered on the accuracy of the Fed’s economic assessments and projections, especially its ability to accurately assess inflation risks. Up to this point, the Fed’s front-line position has left no doubt that the majority of its key current policy-makers remain much more concerned about the sustainability of the post-Great Recession economic recovery than about inflation, as demonstrated by the Fed’s continued extremely accommodative monetary strategies.
Uncertainties about the Actual Strength of the U.S. Economy
But some Fed critics (and governors within the Fed) think that the economic recovery is significantly stronger and more sustainable than the Fed is stating. They argue that the Fed is risking higher inflation and the formation of new speculative asset bubbles (like subprime mortgages and housing, before the Great Recession, or the Tech Bubble in the late 1990s) by continuing such a sustained period of unprecedented monetary accommodation.
One of the trillion-dollar questions of 2012-13 is whether the Fed will further stimulate the recovering U.S. economy (with more measures beyond the low federal funds rate target), or if it will have to scale back the accommodation to address the potentially inflation-fueling/bubble-building momentum of nearly five-straight years of unprecedented accommodative policy moves (dating back to 2007). Or, will it somehow have to both stimulate growth and contain inflation?
Busy Weeks for Fed Communications
Some of the speculation has been fueled by the Fed itself, from its recent statements and speeches, and also from selective releases of information via the central bank’s unofficial (but widely acknowledged) mouthpiece at the Wall Street Journal (WSJ), veteran Fed beat writer Jon Hilsenrath.
The two weeks just prior to the latest FOMC meeting—the weeks beginning February 27 and March 5—were particularly intriguing from a recent Fed communications standpoint. On February 29 and March 1, Fed Chairman Ben Bernanke gave his semiannual monetary policy report to the Congress (what used to be called Humphrey-Hawkins testimony), appearing before the House Financial Services Committee on February 29, and before the Senate Banking, Housing, and Urban Affairs Committee on March 1.
The Approaching “Fiscal Cliff”
Among the biggest attention-grabbers from those legislatively mandated Bernanke appearances was a fiscal-policy warning to Congress, outlining what could happen early next year if Congress continues to waffle and stall on budgetary matters.
Bernanke doesn’t typically highlight fiscal policy (government spending and programs to aid the economy), in his remarks, but in this case he pointedly warned that the U.S. economy faces a potential “massive fiscal cliff” on January 1, 2013 if President George W. Bush-era tax cuts, President Obama’s payroll tax cut, and extended unemployment benefits are all allowed to expire at that time, and $1.2 trillion in automatic mandatory across-the-board spending cuts agreed to last August are allowed to kick in.
As reported by the WSJ and the Congressional newspaper, The Hill, Bernanke warned: “Under current law, on January 1, 2013, there’s going to be a massive fiscal cliff of large spending cuts and tax increases. I hope that Congress will look at that and figure out ways to achieve the same long-run fiscal improvement without having it all happen at one date.”
An Argument to Remain Accommodative
Bernanke warned that allowing tax cuts to expire and trimming fiscal spending could slow economic growth. “You … have to protect the recovery in the near term,” he said. The idea that the recovery might be threatened by the fiscal cliff helped put downward pressure on U.S. stock indices on February 29, according to financial media reports that day.
Because of its potential economic impact, the possible fiscal cliff has been cited by some analysts in defense of the Fed’s continued accommodative policies, adding it to the list of significant headwinds facing the economy this year, which include the weak housing market, high unemployment, tight consumer credit conditions, high gas prices, and unsettled conditions in Europe and the Middle East.
Considering QE3
With short-term U.S. interest rates effectively at 0% for over three years, the Fed hasn’t had much maneuvering room in terms of making monetary policy more accommodative. One alternative that the Fed has pursued pretty aggressively over that period has been quantitative easing (QE—buying U.S. government securities to increase liquidity in the financial system and to keep long-term interest rates low).
We have already seen two recent waves of Fed QE in the U.S. (QE1, from 2008-2010, and QE2, from 2010-11) and a third is being considered, depending on the direction of economic data in 2012. (There’s a favorite saying of economists and analysts that “the decision to execute QE is data-dependent.”)
The primary data that QE depends on are economic growth signals and short-term interest rates—if the economy appears to be in recession or sliding in that direction, and short-term interest rates are too low to cut further, QE may be (and has been) called for.
The Case for “Sterilized QE”
But one of the risks of QE is inflation—adding liquidity and keeping interest rates low can eventually create demand pressures that can push up prices. It can also devalue the dollar relative to other currencies, which is also inflationary. As we mentioned earlier, the Fed now finds itself in a position where it’s still considering another round of QE (QE3) because of economic uncertainties, but it doesn’t want to trigger more potential inflation pressures.
The result: so-called “sterilized QE”—a form of QE described by Hilsenrath in the WSJ on March 7 (in what many speculated was a Fed-planted article) as follows: “The Fed would print new money to buy long-term mortgage or Treasury bonds but effectively tie up that money by borrowing it back for short periods at low rates…employing new market tools they have designed to better manage cash sloshing around in the financial system. Transactions like those… are called ‘reverse repos.’ A related program called ‘term deposits’ also ties up short-term money held by banks.”
Later in the article, Hilsenrath also provided this clarification: “The Fed hasn’t literally printed more money, but it has electronically credited the accounts of banks and investors with new money when it purchased their bonds under quantitative easing.”
Basically, “sterilized QE” is QE with more liquidity controls. We can elaborate on its details in future updates if it looks like it will actually be implemented—we should get more clues from the April and June FOMC meetings. For now, the Fed appears to be just letting us know what options it is considering.
Another interesting thing about this Hilsenrath article was its timing—it appeared the day after the U.S. stock market’s worst performance day of the year (when the S&P 500 dropped over 1.5%, and was down 2.2% over a two-day period), raising speculation that it was timed to help boost the market and confidence (which it apparently did—the S&P 500 rallied 3.9% over the next five sessions). This, along with the “fiscal cliff” example, show how closely tuned the markets are to what the Fed is saying and how they’re tracking what its intentions are.
The Continued Case for Inflation Protection
What’s the lesson for investors from all of this? We suggest being prepared for several different economic and market scenarios in 2012. In other words, stay diversified. If the Fed—with all of its research tools and economic brainpower at its disposal—is uncertain about the economic outlook, we all should tread lightly.
As the President and Chief Executive Officer of American Century Investments, Jonathan Thomas, has been writing to fund shareholders in our shareholder reports this year: “More market volatility appears likely in 2012…as uncertainties regarding European debt, economic strength, government budget deficits, and the U.S. presidential election sway investors. We believe strongly in adhering to a disciplined, diversified, long-term investment approach during volatile periods.”
We also believe in striving for inflation protection. Both the Fed and its critics appear to be giving serious consideration to the longer-term inflation implications of the past nearly five-straight years of accommodative monetary policies, and we suggest investors should too. To serve investors’ needs, American Century Investments offers a suite of funds that aim to provide various forms of inflation protection, utilizing holdings that include commodity and precious metal-linked securities, foreign securities and currencies, and inflation-linked bonds.
American Century Investments® offers a wide variety of stock, bond and asset allocation funds. Visit americancentury.com for more information: Individual Investors | U.S Investment Professionals
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The opinions expressed are those of Robert V. Gahagan and the fixed income portfolio management team at American Century Investments, and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.
Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.
Diversification does not assure a profit, nor does it protect against loss of principal.
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