The Fed’s Poppycock Monetary Policy Targets the Unemployment Rate

Well, we did not discover any new secrets of the financial universe while lawn bowling. But it was a nice day. And as we got to the office this morning, we learned that the Federal Reserve has tried to rewrite some of the laws of economics. At the very least, the Fed is confirming to investors that it will persist with this ‘monetary easing‘ for as long as it takes, which could turn out to be a very long time.

As expected, the Fed will continue buying $40 billion a month in mortgage backed securities. This shows you that the US mortgage market hasn’t even come close to recovering. The Fed has to buy bonds from Fannie Mae and Freddie Mac to ensure an orderly market. Private lenders, knowing that millions of Americans have mortgages in zombieland (underwater, but not foreclosed on), don’t want anything to do with the mortgage market.

Also as expected, Operation Twist will be continued by other means. Put another way, the Fed will buy US Government bonds and notes because it has to, even if it means printing money. This will continue at the pace of around $45 billion per month. The gold price spiked $12 on this news, but gave back most of those gains later in the day.

Still, we’d expect December 12th to be an important day in monetary history. Why? The Fed explicitly targeted the US unemployment rate. Instead of giving a vague date in the future when it said interest rates would rise, it said interest rates would not rise until the unemployment rate in the US falls below 6.5%. You can read the whole statement at the Fed’s website, but here’s the relevant bit (emphasis added is ours):

‘To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens.

In particular, the Committee decided to keep the target range for the federal funds rate at 0 to ¼ per cent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 per cent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 per cent longer-run goal, and longer-term inflation expectations continue to be well anchored.

The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labour market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 per cent’

Traditionally, inflation and unemployment are mutually exclusive goals in monetary policy. If you lower rates, the economy picks up speed and enters a credit-financed boom. Unemployment goes down but prices rise. Or, to cool off a boom (this must be how the monetarists think anyway), you raise rates. Unemployment rises but prices are stable.

In its latest move, the Fed aims to have both lower employment and lower inflation. You can tell it’s worried about inflation because it says so above. It doesn’t want its new stance to cause inflation to run ahead of its two-year projection. It wants inflation, but just a little, and just enough to bring unemployment down.

It’s all a bunch of utter poppycock, of course. You can’t create employment with asset purchases any more than you can ride a bicycle to the moon. The Fed can’t do a thing to get businesses hiring again. All it can do is prevent more bankruptcies and insolvencies by keeping interest rates low. It seems prepared to do this.

The reaction of stocks was worth taking a look at. After 2pm, once the announcement was public, stocks sold off. They closed up on the day, but only just. And you can almost see the gears turning in investors’ heads: the Fed is out of ammo. All it can do now is keep asset prices on life support.

S&P 500 large cap index

Source: StockCharts

In the context of the currency wars, this tells everyone else what the battlespace will look like for the foreseeable future. The weak US dollar is by design. If it makes your currency strong and creates problems for you, too bad. Deal with it. Over to you RBA….


Dan Denning
for Markets and Money

From the Archives…

Will Lower Interest Rates Impact Australia in 2013?
7-12-2012 – Greg Canavan

Is the Australian Economy in Recession?
6-12-2012 – Greg Canavan

US Debt: Why America May Need a Bail Out by the IMF
5-12-2012 – Bill Bonner

If Profits are Falling Why are Stocks Rising?
4-12-2012 – Dan Denning

The Frontier Way
3-12-2012 – Dan Denning

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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