January 25, 2012
Coaches love to preach the fundamentals. There is a story, possibly apocryphal, about Green Bay Packers coach, Vince Lombardi, addressing his team after a particularly egregious loss. Pointing to an object on his desk, he said, "Gentlemen, this is a football." A player, standing towards the back, is said to have responded, "Uh, coach, could you go over that again."
Still, it's not a bad idea to go review the fundamentals now and then, even for those who are, or are supposed to be, seasoned professionals. Today, the Federal Open Market Committee, the policy arm of the Federal Reserve System, went back to basics in explaining its purposes and actions. Finance professionals may skim past these background parts of FOMC's press releases, issued following a two-day policy meeting. But they are extremely, indeed fundamentally, important. The FOMC, after all, is not talking just to professionals. The Committee is talking to everyone who is affected by monetary policy; which is to say, everyone. "The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decision-making by households and businesses…" (emphasis added). "Transparency and accountability…are essential in a democratic society."
It doesn't get more fundamental than that, and we should take the FOMC's announcements at face value. We are so distrustful of public officials and so used to looking behind their words for the real, hidden, meaning that we have all but lost the facility of belief. I am not asking you to agree or disagree with the FOMC's statements. I do urge you to believe the Fed means precisely what it says, and for that reason, consider its points seriously.
The statements continually reference the Fed's dual statutory mandate, "to foster maximum employment and price stability." Every word here is important. The mandate is "dual" because both parts are equally important, and they contain the entirety of what the Fed is empowered to do. It has often been noted that the two goals can be contradictory. Jobs tend to be created quickly when the production of goods and services heat up to meet demand, but ultimately the cycle can turn inflationary as prices spiral out of control. Stable price tend to retard employment because people have less money to spend resulting in less production of goods and services. Here the danger is that the economy will stall and fall into recession. Economies rarely stay in equilibrium for long. But, it's the Fed's responsibility to balance the two mandates. Second, the mandate is "statutory;" Congress has specified by law what the Fed is required to do. Intervening in the economy in other ways would not just be misguided but illegal. In its statements, the FOMC emphasizes its responsibilities and authority with great clarity because it wants you to understand clearly what it can and cannot do.
At present, the Fed believes
- "The unemployment rate remains elevated" and "the unemployment rate will decline only gradually towards levels that the Committee judges to be consistent with its dual mandate." (Mandate #1), and
- "Over coming quarters, inflation will run at levels at or below those consistent with the Committee's dual mandate." (Mandate #2)
For the first time ever, the Fed specifically defines the optimum levels of inflation and unemployment. An inflation rate of 2%, as measured by the annual change in the price index of personal consumption expenditures (PCE), will be the Fed's long-term inflation target. Determining an ideal unemployment rate is, surprisingly, more difficult. You might think the best unemployment rate is 0%, but in a healthy economy there are always people changing jobs voluntarily as well as a certain amount of creative destruction leading to involuntary job losses. The economy's health is demonstrated by how quickly people get new jobs. The Fed has established a target range of 5.2% to 6.0% for unemployment, while emphasizing that, unlike inflation, this range can be expected to vary over time.
Directly following on these conclusions, the FOMC announced three actions to achieve its mandates:
- It will maintain the fed funds target rate—that is, the rate banks pay for overnight loans from other banks—between 0% and 0.25%;
- It expects to maintain the fed funds rate at these extremely low levels "at least through late 2014."
- It will continue its purchases, and extend the maturities, of long-term US Treasury bonds and similar securities.
To many people, these actions may seem meager and extraneous to the real problems of the economy. Herein lies the Fed's communication problem. In practice, the actions outlined by the Fed do have a substantial economic effect. Very low short-term interest rates anchor all interest rates at low levels. The announcement that short-term rates will be kept low for three years—virtually a millennium the way the financial markets measure time—encourage a long-term investment horizon at current rates. Investors and lenders need not fear that their assets will lose value quickly due to rapidly rising interest rates. Finally, the Fed's continued purchases of very large amounts of bonds are simply an application of the law of supply and demand. The more the Fed buys, the less other investors can buy. Hence, bond prices are kept high and interest rates low.
The bottom line is that our nation's central bank expects the economy to grow slowly and below its potential for years to come. The Fed's policy makers intend to use the bank's powers to their utmost to lessen and shorten the period of economic malaise. But, as the FOMC points out, we live in a democratic society, not a command economy. All that the FOMC can do is "maintain a highly accommodative stance for monetary policy;" that is, it can use its tools to keep short-term interest rates low. Low interest rates should encourage more borrowing and lending, which in turn should fuel economic activity. But the Fed cannot order economic conditions to its liking. Again, you don't have to agree with the FOMC's opinions or methods. But understand that, today, the Fed has made some fundamental statements, which they will live by and we will all live with.