Parsing the Fed's Statement

Contraction Slowing, Inflation Not Immediate

The Fed’s statement from this month’s meeting is presented below, along with its previous statement from the April meeting and my interpretation and commentary interspersed.

"Information received since the Federal Open Market Committee met in April suggests that the pace of economic contraction is slowing. Conditions in financial markets have generally improved in recent months. Household spending has shown further signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit. Businesses are cutting back on fixed investment and staffing but appear to be making progress in bringing inventory stocks into better alignment with sales.

"Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability."

"Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract, though the pace of contraction appears to be somewhat slower. Household spending has shown signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth and tight credit. Weak sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories, fixed investment and staffing.

"Although the economic outlook has improved modestly since the March meeting, partly reflecting some easing of financial market conditions, economic activity is likely to remain weak for a time. Nonetheless, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability."

A bit more upbeat in tone, since they omitted the part about continuing to contract and just left the part about the pace of contraction slowing. An English major might object that even if slowing, if it has not stopped -- it is continuing -- but nobody has ever judged an FOMC statement on its literary merit.

The rest of the paragraphs are pretty much the same. The economy is no longer falling off of a cliff, but that does not mean that it is recovering yet. Inventory restocking may help a bit in the short term, but that is not a good driver of long-term economic growth.

While the economic Armageddon scenario is now off the table, a Japanese-style "lost decade" is becoming more and more likely. The Fed is more or less ruling out a V-shaped recovery.

"The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time."

"In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term."

While at first glance the statements look similar, there are some significant differences. In the April statement they referred to "inflation could persist for a time below rates that best foster economic growth and price stability in the longer term" which is Fed-speak for deflation. The Fed seems to be indicating that deflation concerns are off the table.

They also have acknowledged the recent rise in commodity prices, most importantly for oil. This sets up a very real possibility for a big divergence between core and headline inflation. If this is the case, then being invested in the oil companies like Exxon (XOM - Analyst Report) or deep-sea drillers like Transocean (RIG - Snapshot Report) would be a good place to be.

The resource slack is apparent in the labor market with an unemployment rate of 9.4% and rising, and in the industrial sector with record low rates of capacity utilization. The low capacity utilization figures means that one wants to avoid firms that make industrial equipment, like Ingersoll Rand (IR - Analyst Report).

"In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

"As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn.

"The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted."

"In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent, and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

"As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn.

"The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of financial and economic developments."

No real change in this section of the statement. The Fed funds rate is going to be pegged close to zero for the foreseeable future, and there is no change in the amount of non-traditional assets (Agency MBS, debt and long-term T-notes) the Fed is planning on buying. This is not really a surprise, but it will also probably come as a relief to the bond market that the pace of quantitative easing is not accelerating.

As it is, it will be very difficult for the Fed to pull back from these programs once the economy does gain some traction. Unless they are able to do so in a timely fashion, they have sown the seeds for much higher inflation down the road. However, high inflation is likely to be a late 2010 or 2011 issue, not a 2009 issue.

"Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen."

"Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen."

Peace and harmony prevailed at the meeting -- everyone agreed with the statement.