'New tool box' likely to be focus of Fed's meeting

Posted Dec 16th 2008 11:58AM by Joseph Lazzaro
Filed under: Federal Reserve, Recession, Financial Crisis

What should investors focus on when the U.S. Federal Reserve announces its interest rate decision Tuesday at 2:15 p.m. EST?

The amount of the cut in short-term interest rates? No. A rate cut in its benchmark rate of 50-75 basis points from 1% is all but assured, given the recession.

The Fed's statement on economic conditions? Typically, the statement would be parsed by economists and analysts, and they'll watch for some change in tone, but, really don't expect any revelations in the top part of the statement. Economic conditions are poor, almost across the board, and have been so for a while, so Wall Street is not likely to read anything it doesn't already know about the major economic indicators.

Fed's new tool box

Rather, investors should look for any clues the Fed might provide regarding continuing use of non-traditional methods, i.e. the Fed's 'new tool box,' including quantitative easing. In its last statement, the Fed identified "extraordinary liquidity measures" as one official step that was strengthening the financial system. If the reference to extraordinary liquidity measures is retained, there's a decent chance there's more quantitative easing up ahead, if economic fundamentals do not improve.

Quantitative easing involves increasing funds in the financial system after the Fed loses the ability to lower the cost of money from an interest rate standpoint. Basically, the Fed adds cash by purchasing Treasuries, agency debt, and if the need arises, other asset-backed securities, hoping that some of that money will be lent or otherwise deployed in commercial operations.

The size of the resources available for quantitative easing policy varies on how much money the Fed believes it has to deploy, so says economist David H. Wang. One school argues that the amount of money available is up to a set percentage of U.S. GDP, for example 15% or 20%, he said. However, another school argues that the amount of money is much larger than that, Wang added.

The Fed's balance sheet has surged to $2.2 trillion in November from about $924 million in September, when the first wave of the financial crisis began to freeze credit markets and decimate stock markets around the world. For example, the Fed is on the hook for up to $240-$265 billion as a result of the rescue of Citigroup (NYSE: C).

The Fed's hawks are certain to voice concerns about inflation stemming from the quantitative easing, but their argument looks less and less strong by the month. De-leveraging, risk aversion, the flight-to-safety, and an unwillingness to deploy capital tilt the balance of risks toward deflation, Wang said. "The Fed's goal now, along with the fiscal policy, is to create demand and reverse the recessionary vicious circle of revenue declines, lay-offs, and home foreclosures," Wang said. "It's priority No. 1 until GDP growth resumes."

Monetary Policy Analysis: The view from here argues that the Fed must and will remain focused on keeping markets liquid and, along with fiscal policy, creating demand. Having too much money in the system and prices rising assumes economic growth is occurring, and wouldn't the U.S. like to have that problem in six months?

Tags: Bernanke, Fed, interest rates, inthenews, monetary policy, quantitative easing