Kristina Hooper, CFP®, CIMA® is head of portfolio strategies for Allianz Global Investors Distributors LLC. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
Whether it’s buying bonds or extending record-low interest rates until 2015, the Federal Reserve may not keep its powder dry much longer. And last week’s release of the minutes from the Federal Open Market Committee‘s July 31-Aug. 1 meeting offered substantial insight into what committee members are thinking.
Their discussion covered weak consumption growth, low refinancing activity, moderate inflation rates and downside risks related to strains in the financial system. Specifically, FOMC members cited concerns over contamination from the ongoing euro-zone crisis and the impending U.S. fiscal cliff as significant threats to the economy.
The dialogue was in line with a report released last week by the Congressional Budget Office, which highlighted the impact of expiring tax policies and automatic spending cuts slated to take effect in January 2013. If such policy changes are allowed to occur, the CBO predicts that the federal deficit for 2013 will decrease significantly, falling to an estimated $641 billion, or 4% of GDP. That would be nearly $500 billion less than the shortfall in 2012. But it comes at a price: “Such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession, with real GDP declining by 0.5 percent between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9 percent in the second half of calendar year 2013,” the CBO projects.
The FOMC is clearly concerned about a slowdown too. In fact, many members of the FOMC believe that, in the absence of data indicating both substantial and sustainable economic improvement, additional monetary accommodation will be needed “fairly soon.” Perhaps most interesting was the discussion of the possible tools that the Fed could potentially use. The FOMC analyzed the “benefits and costs of a new large-scale asset purchase program.” It was reported that many committee members anticipated that such stimulus could support the economic recovery by putting downward pressure on longer-term interest rates and “contributing to easier financial conditions more broadly.” In addition, reports circulated that some of the participants felt such a program could not only further the FOMC’s efforts toward its mandated objectives, but also it could increase business and consumer confidence. The Fed clearly recognizes its critical role—both monetarily and psychologically.
It was encouraging to see the Fed highlight the relatively strict lending standards that are negating some of the effectiveness of low interest rates. Despite “new historical lows” for residential mortgage rates recently, “refinancing activity remained relatively muted,” according to the FOMC minutes. The Fed cited results from the July senior loan officer opinion survey on bank-lending practices, which indicated that “mortgage underwriting standards at banks generally have not eased much from their tightest post-crisis levels.” This was just one of many concerns the Fed has about where the economy is headed.
A September to Remember
Our view at Allianz Global Investors is that there is an increasing chance that the FOMC will take additional policy action at its Sept. 13 meeting. There are several options the Fed could take to guard against further economic weakness. Extending the period of exceptionally low interest rates from 2014 to 2015 is a possibility. We also believe intervention in the mortgage-backed securities market in order to stimulate refinancing activity is another option for the Fed. We also believe the Fed could initiate another round of quantitative easing in the U.S. Treasury market.
But this is by no means a done deal. There are clearly good arguments to support Fed inaction. First, inflation is likely to rise in the coming months as commodity prices, both agriculture and energy, have risen over summer. In addition, economic data released after the last FOMC meeting have indicated moderate growth and, on balance, have not shown further deterioration. This includes data on consumption, housing, the labor market and sentiment surveys.
Examining FOMC minutes provides us with far greater transparency and understanding than analyzing the size of the Fed chairman’s briefcase, a common practice during former Fed Chairman Alan Greenspan’s era. The press and the pundits say a fatter chairman’s briefcase indicates an imminent interest-rate change, while a thinner briefcase suggests rates will remain unchanged. But it’s not always the best indicator. In May 2000, for example, despite the fact that Greenspan's briefcase was at its thinnest in years, the FOMC raised its interest-rate target by half a percentage point, marking the largest increase in five years.
Today, we have far more insight into the FOMC’s concerns and the likelihood of its actions, but we still don’t have complete clarity. Hopefully, we’ll gain further insight when Fed Chairman Ben Bernanke delivers his speech at Jackson Hole later this week.
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