The Fed Inches Toward the Exit

Policymakers kept rates unchanged at the conclusion of their Dec. 15-16 meeting, but set the stage for efforts to drain massive liquidity from the financial system

By Michael Wallace

The Federal Open Market Committee—the policy-setting arm of the Federal Reserve—chose to stay the course heading into yearend. At the conclusion of its Dec. 15-16 policy meeting, the committee's time-tested "exceptionally low levels of the federal funds rate for an extended period" phrase survived another meeting intact.

But in its post-meeting statement, the FOMC indicated that it will eventually wring out excess liquidity in the financial system starting in discrete stages next year. In fact, more details were provided about the Fed's natural escape plan for "special liquidity facilities" in a new final paragraph.

The statement itself subtly upgraded the economic outlook, but retained the same patience on tolerable inflation risks given resource slack in the economy. There was only minor rebalancing of views on growth and inflation risks, and we got more detail in the statement about the timing of the expiration of the Fed's liquidity facilities next year.

Policymakers not only repeated that economic activity has "continued to pick up," but noted that the deterioration in the labor market is "abating."

The board also interjected that "financial market conditions have become more supportive of economic growth." The language on inflation risks, however, was left identical to the prior statement, and the vote was a unanimous 10-0.

Economic Outlook

The Fed addressed the economic outlook thus: "Information received since the Federal Open Market Committee met in November suggests that economic activity has continued to pick up and that the deterioration in the labor market is abating. The housing sector has shown some signs of improvement over recent months. Household spending appears to be expanding at a moderate rate, though it remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit."

Businesses, however, are still cutting back on fixed investment, though at a slower pace, the Fed noted, and remain reluctant to add to payrolls; they continue to make progress in bringing inventory stocks into better alignment with sales. Meanwhile, "[f]inancial market conditions have become more supportive of economic growth."

Although the Fed indicated that it expects economic activity is likely to remain weak for a time, the FOMC "anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability."

As for inflation: "With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time."

Monetary Policy

The paragraph from the Nov. 4 statement dealing with the Fed's policy and quantitative easing strategies, having grown ponderous, was more efficiently split into two pieces in the December communiqué. The committee said it will maintain the target range for the federal funds rate at 0 to 1/4 percent, and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, "are likely to warrant exceptionally low levels of the federal funds rate for an extended period." To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Fed maintained its plan to purchase $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt.

The Fed said it is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter of 2010.

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