US Federal Open Market Committee November 2010

The US Federal Open Market Committee (FOMC) decided to keep the federal funds target rate unchanged at 0.00% to 0.25% for an extended period of time. This was in line with market expectations. In addition, the Federal Reserve indicated that they will purchase a further $600bn of government securities, mainly in the 5 to 10 year area (explanation note released by the New York Federal Reserve) over the next 8 month period to the end of Q2 2011.

In making the decision the FOMC made the following key comments about the outlook for growth and inflation:

Growth:

• The pace of recovery in output and employment continues to be slow.
  
  
• Household spending is gradually increasing, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.
  
  
• Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak.
  
  
• Employers remain reluctant to add jobs.
  
  
• Housing starts continue to be depressed.

Inflation:

• Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters.
  
  
• Although the Committee anticipates a gradual return to higher levels of capacity utilization, progress toward its objectives has been disappointingly slow.

Quantitative Easing (QE) announcement:

• The Fed will maintain its existing policy of reinvesting principal payments from its securities holdings.
  
  
• In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, at a pace of about $75 billion per month.
  
  
• The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

It is worth noting that Thomas Hoenig once again voted against the decision, arguing that risks of additional QE purchases out-weigh the benefits.

Overall, the Federal Reserve is arguing that because it has a dual mandate of managing both growth and inflation and because it is missing both objectives on the low side, it has to do more QE (mainly because there is little else it can do). The amount of QE announced is very much in-line with market expectations, which means, it is giving the market what is already priced in. Nevertheless, the announcement will still tend to weaken the Dollar and further strengthen emerging market currencies, such as the Rand. The reaction of the bond market will be determined by whether or not the market anticipates a QE3 announcement next year and also any change in inflation expectations (these two factors are now critical to the bond call).

Lastly, the Fed is already expected to buy around $250 to $300 billion of government securities over the next 8 months, simply by re-investing the principal payments received from agency debt and agency mortgage-backed securities. Taken together, the Fed anticipates conducting $850bn to $900bn purchases of longer-term government securities by the end of Q2 2011. That is a lot more liquidity going into a system that already has a huge amount of additional liquidity, which has thus far proved to be fairly ineffective.

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