Last week, the Federal Reserve released the minutes of its Open Market Committee meeting that concluded on June 23.¹ Meeting participants were hopeful that the economic rebound would continue, yet a number of statements from the minutes highlight the slowdown in the US economy. Additionally, the Fed minutes note an increase in "fails to deliver" securities, which could signal that the limit of quantitative easing already has been reached because of a lack of liquid securities.
The following excerpts from the minutes of the Federal Reserve's Open Market Committee meeting demonstrate that Federal Reserve members are aware of a slowdown in the economy:
Economic data releases were mixed, on balance, over the intermeeting period, but market participants were especially attentive to incoming information on the labor market--most notably, the private payroll figures in the employment report for May, which were considerably weaker than investors expected. Those data, combined with heightened concerns about the global economic outlook stemming in part from Europe's sovereign debt problems, contributed to a downward revision in the expected path of policy implied by money market futures rates.
...While the recent data on production and spending were broadly in line with the staff's expectations, the pace of the expansion over the next year and a half was expected to be somewhat slower than previously predicted.
...The implications of these less-favorable factors for U.S. economic activity appeared likely to be only partly offset by lower interest rates on Treasury securities, other highly rated securities, and mortgages, as well as by a lower price for crude oil. The staff still expected that the pace of economic activity through 2011 would be sufficient to reduce the existing margins of economic slack, although the anticipated decline in the unemployment rate was somewhat slower than in the previous projection.
...In part as a result of the change in financial conditions, most participants revised down slightly their outlook for economic growth, and about one-half of the participants judged the balance of risks to growth as having moved to the downside.
...Indeed, data for the most recent month suggested that, with the expiration of those provisions, home sales and starts had stepped down noticeably and could remain weak in the near term; with lower demand and a continuing supply of foreclosed houses coming to market, participants judged that house prices were likely to remain flat or decline somewhat further in the near term.
...The economic outlook had softened somewhat and a number of members saw the risks to the outlook as having shifted to the downside. Nonetheless, all saw the economic expansion as likely to be strong enough to continue raising resource utilization, albeit more slowly than they had previously anticipated.
...In sum, the changes to the outlook were viewed as relatively modest and as not warranting policy accommodation beyond that already in place. However, members noted that in addition to continuing to develop and test instruments to exit from the period of unusually accommodative monetary policy, the Committee would need to consider whether further policy stimulus might become appropriate if the outlook were to worsen appreciably. Given the slightly softer cast of recent data and the shift to less accommodative financial conditions, members agreed that some changes to the statement's characterization of the economic and financial situation were necessary.
...About one-half of the participants saw the risks to their growth outlook as tilted to the downside; in contrast, in April a large majority of participants saw the risks to growth as balanced.
In the past, statements acknowledging an economic slowdown would have prepared market participants for the possibility of interest rate cuts. Economists would have projected interest rate cuts into their forecasts and highlighted the benefits of lower rates for the stock market and the economy. However, with the federal funds rate currently at 0%, interest rate cuts cannot be a part of the arsenal used to combat an economic slowdown.
Few market commentators are discussing how the inability to cut interest rates will increase the likelihood and the severity of a downturn. This is surprising because there have been recessions even when the Fed could lower interest rates. In contrast, complacency exists because it is widely accepted that the Federal Reserve has other tools to support the economy and stock market. However, additional action by the Federal Reserve would signal its failure to revive the economy. Therefore, we believe that the Fed is unlikely to use a "nuclear option" until there is a stock or credit market panic.
Regardless of the timing of further Fed policy action, it is unlikely that additional quantitative easing will lead to more than just a temporary bounce in asset markets. For one, Japan's history demonstrates that continuous quantitative easing does not necessarily lead to sustained economic growth or to higher stock prices. Additionally, a further decline in long-term interest rates on mortgages and government bonds is unlikely to be as stimulative as in the past since rates are already so low. Finally, the following statement from the minutes of the Federal Reserve's Open Market Committee meeting could mean that quantitative easing has reached its practical limit:
In his presentation to the Committee, the Manager noted that 'fails to deliver' in the mortgage-backed securities (MBS) market had reached very high levels in recent months. Under these conditions, dealers had experienced difficulty in arranging delivery of a small amount--including about $9 billion of securities with 5.5 percent coupons issued by Fannie Mae--of the $1.25 trillion of MBS that the Desk at the Federal Reserve Bank of New York had purchased between January 2009 and March 2010. The Desk had postponed settlement of some of these transactions through the use of dollar rolls. The Manager discussed alternative methods of settling the outstanding transactions and recommended that the Committee authorize the Desk to engage in coupon swap transactions to facilitate the settlement of these purchases. The Manager noted that a coupon swap is a common transaction in the market for MBS in which the two counterparties exchange securities at market prices. By engaging in a coupon swap, the Federal Reserve would effectively sell the scarce securities that it had not yet received and purchase instead securities that are more readily available in the market. After discussing various approaches, meeting participants agreed that coupon swaps were an appropriate method to achieve settlement of outstanding transactions.
The uncommon mention of "fails to deliver" makes us wonder if the Federal Reserve is running out of assets to buy, and therefore, also running out of policy options. While the Federal Reserve may announce an increase in quantitative easing by trillions of Dollars, if it is unable to find liquid securities to buy, the policy move may provide little value beyond an initial stock market squeeze.
Members of the Federal Reserve recognize that a slowdown is ahead but they lack the traditional tools to stimulate the economy. Although increased quantitative easing is a strategy that the Federal Reserve can pursue, it is unlikely to be effective.
¹ http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20100623.pdf
