Fed keeps rates unchanged, amidst insufficient pace of economic recovery

The economic recovery is continuing, but at a pace that is not sufficient to bring down unemployment, according to a policy statement by the Federal Reserve’s Federal Open Market Committee (FOMC).

As expected the Fed kept the federal funds rate unchanged at 0 to 0.25 percent, with the expectation that economic conditions “are likely to warrant exceptionally low levels for the federal funds rate for an extended period. “

In addition, the FOMC re-affirmed its commitment to purchasing $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, or a pace of about $75 billion per month.

The FOMC statement was quite dour on the economy, and did not mention some recent benevolent developments, such as the likely extension of the Bush-ear tax cuts and a reasonably strong Thanksgiving/Christmas holiday retail shopping season.

“Household spending is increasing at a moderate pace, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit,” the committee wrote.

“Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in non-residential structures continues to be weak. Employers remain reluctant to add to payrolls. The housing sector continues to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have continued to trend downward.”

The FOMC also said that progress towards its dual objectives of maximum employment and price stability has been “disappointingly slow.”

“The Fed was always going to leave the size of QE2 unchanged today as it is too soon to judge whether it has been a success or a failure” commented Paul Dales, senior U.S. economist at Capital Economics.

“And although the case for QE2 may have diminished, an outright tightening of monetary policy is some years away yet.”

Dales also indicated that the FOMC statement made no reference to the proposed second fiscal stimulus, but that surely puts less of the burden to boost growth on the Fed.

“These developments explain why the markets are not convinced that the Fed will complete the $600-billion of Treasury purchases announced at the last meeting in early November,” he said. “Nonetheless, the Fed was never going to perform a u-turn just six weeks later.”

Given that it usually takes 18-24 months for changes in rates to have their full effect on the economy, monetary stimulus is now only coming from the Fed's asset purchases, Dales added.

“Even if QE2 proves to be the Fed's last roll of the dice, we believe that the markets are mistaken in expecting policy to be tightened in early 2012,” he said. “Continued high unemployment and low inflation mean we would not be surprised to see interest rates remain at near-zero for at least another full two years.”

Once again, board member and Kansas City Fed President Thomas Hoenig voted against the rest of the Committee, citing that he is “concerned that a continued high level of monetary accommodation would increase the risks of future economic and financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy.”