The Fed Warms Up The Helicopter

Prajakta Bhide and Christian Menegatti
08.19.10, 06:00 AM EDT

With the interest rate parked at zero and inflation below target and falling, the Federal Reserve concocts a new plan.

With one key sentence, the statement from the August Federal Open Market Committee (FOMC) meeting indicated changes afoot.

Prior to the Aug. 10 meeting, the emergence of a string of unimpressive economic data, including a dismal jobs report, put significant pressure on the Fed to show some cognizance of the stalling recovery. As anticipated, the Fed maintained its pledge to keep the federal funds target low for an extended period. More notable, however, is the committee's announcement that it plans to reinvest the principal payments on the Fed's mortgage-backed securities (MBS) and agency debt in Treasurys, thereby implicitly capping the Fed's securities holdings at current levels and ending the passive tightening from the runoff of its portfolio.

We have been seeing the Fed laying verbal groundwork for further monetary stimulus, which we consider warranted, and the latest announcement appears to be another signal of a forthcoming gradual policy shift. On its own, though, the latest move is likely to have limited implications for the broader economy. (For details on the expected impact of the intended purchases on Treasury yields, see this RGE Strategy Flash.)

We are not the only ones who have been saying the Fed needs to credibly commit to providing additional monetary stimulus to boost demand and alleviate deflation risks. One of the Fed's own, St. Louis Fed President James Bullard, in late July published a report highlighting research that indicates that “the U.S. is closer to a Japanese-style outcome today than at any time in recent history.â€