In a statement on Aug. 10, the Federal Reserve’s Open Market Committee changed its time horizon for maintaining short-term interest rates. The following sentence was a radical departure from previous statements:
“The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. “
What does it mean? The initial positive reaction in the stock market the following days suggests the statement was widely interpreted to mean the Fed will be providing a significant degree of monetary stimulus for at least the next two years.
Relevant Information Lacking
While this well may be the case, it ain’t necessarily so, as reflected in wild gyrations in the market in following days. As usual the Fed’s Statement failed to provide relevant information about its conduct of monetary policy. Short-term interest rates do not guarantee ample liquidity.
During the Great Depression, the most restrictive monetary policy occurred with interest rates at 0 percent. More recently, the Fed stopped increasing bank reserves during 2010. This year, the Fed increased reserves at double-digit annual rates through July.
Throughout both periods, the Fed funds rate was close to zero. Saying the Fed funds rate will remain at zero for two years doesn’t automatically mean monetary policy will be expansive.
Capital Rebuilding Pressure
The Fed has plenty of tools it can use to offset the normally expansive impact of low short-term interest rates. For example, Fed regulators have been pressuring banks to reduce their assets in an effort to rebuild capital. This behavior tends to produce less liquidity than normal for a given amount of bank reserves. As such, it tends to restrict the impact of monetary policy on spending.
The Fed can also either raise reserve requirements or boost the interest rate it pays banks to keep their deposits with the Fed. Either of these moves could produce monetary restraint at the same time interest rates remain low.
The Fed may well adopt the type of highly expansive monetary policy the stock market’s initial behavior seemed to suggest. However, without a more informative statement about how it intends to conduct policy, the central bank hasn’t provided the necessary information needed to determine its future policy.
We know the Fed intends to provide monetary stimulus, but we still don’t know if it will achieve its intention.
Robert Genetski, Ph.D., one of the nation’s leading economists and financial advisors, has spent more than 35 years promoting the use of classical economic and investment principles for sound financial decisions. He heads ClassicalPrinciples.
