December 14, 2010

Fed Confirms Monetary Policy, QE2 as Currency War Prospects Rise

FOMC keeps Fed funds rate near zero, eyeing continued low inflation

The Federal Reserve Board's Open Market Committee (FOMC) announced no change to U.S. monetary policy on Tuesday, leaving its plans intact for a $600 billion round of quantitative easing as the world’s central banks prepare for a currency war that pits developed countries against emerging economies.

The Federal Reserve’s policymakers said in their Dec. 14 announcement that the committee will maintain its policy of reinvesting principal payments from securities holdings and that it intends to purchase $600 billion of longer-term Treasury securities—a program also known as QE2—by the end of the second quarter of 2011, a pace of about $75 billion per month. Also, the FOMC will maintain the target range for the federal funds rate at its historic lows of 0% to 0.25%.

In announcing its decision to continue with monetary easing, the FOMC pointed to the nation’s stubbornly high unemployment rate of 9.8% and downward-trending inflation.

“Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the committee judges to be consistent, over the longer run, with its dual mandate,” the FOMC's formal announcement read. “Although the committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.”

Analysts, who expected the Fed to stand pat, were unsurprised by the FOMC’s announcement.

“The Fed will clearly maintain its easy money stance until employment improves substantially. The only item that might possibly change this is a substantial increase in inflation. This is consistent with the Fed’s dual mandate of price stability and full employment,” said Doug Roberts, chief investment strategist for ChannelCapitalResearch.com in Shrewsbury, N.J.

But outside of the United States, many central-bank watchers are unhappy about the Treasury debt purchase program’s objectives, which many suspect is designed to inject enough liquidity into the economy to encourage exports by making the dollar weaker. Talk of a currency war, in which countries devalue their currencies to gain a trade advantage, now dominates the foreign-exchange headlines.

In a 2011 outlook, LPL Financial Corp.’s currency analysts said that a weaker

 

 

dollar may benefit the United States by boosting inflation “as the Fed seeks to avoid the demand-destroying effects posed by the threat of deflation, or falling wages and prices.” However, they added, “these policies create challenges for the emerging market countries where growth is currently strong, but increasingly pressured by a rising currency that threatens to reduce the global competitiveness of their exports and create a bubble in their economies as the world’s capital increasingly pours into their borders.”

Brazil’s finance minister has warned of an international currency war and called for some kind of currency agreement, while India’s prime minister has expressed similar concerns and the governor of the Bank of England has warned of protectionism unless “the need to act in the collective interest” is recognized, the LPL analysts noted.

Talk about the euro’s stability is also heating up. In Europe on Sunday, German finance minister Wolfgang Schauble voiced support for the euro in a published interview in Bild in which he said calls to restore the German deutschemark amounted to “unrealistic nostalgia.”

European leaders will amend the European Union (EU) treaty this week to accommodate the creation of a permanent European Stability Mechanism (ESM) that will begin in 2013. According to a Reuters report, the summit gathering decided in favor of inserting two sentences into the EU treaty that will facilitate the new ESM. It will not only present the possibility of investors absorbing some losses in case of a sovereign debt restructuring but will also put pressure on governments to focus on sound fiscal policy and, in theory at least, hold off another debt crisis.

Of note in the FOMC’s announcement on Tuesday, the lone dissenting voice against the decision to stand pat was Thomas Hoenig, who has consistently voted against quantitative easing in 2010. Hoenig, who won’t be voting next year under the FOMC’s rotation system, expressed concern in light of the improving economy 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. (In a recent opinion piece, Hoenig also called for the return of Glass-Steagall.)

Just a month ago, the Fed announced its QE2 plan on Nov. 3, a day after the midterm elections handed control of the U.S. House back to the Republicans. Then, the FOMC agreed to keep interest rates at historic lows and to pursue a course of quantitative easing with the purchase of U.S. Treasuries. It voted to buy $600 billion of longer-term Treasury securities by the end of second-quarter 2011 and to maintain the target range for the federal funds rate at zero to 0.25%.

Read about the Fed’s most recently released meeting minutes at AdvisorOne.com.

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