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Brightening economic signals fail to move Fed

June 18, 2014

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

interest rates

Today's Federal Reserve meeting yielded no material change in monetary policy, despite recent evidence of a revival in economic growth and inflation.

Immediately following the conclusion of its June 17-18 meeting, the Federal Open Market Committee announced it was sticking to its recent course: another $10 billion cut to monthly bonds purchases, and the maintenance of short-term interest rates near zero.

Although the cautious cuts to those stimulative bond purchases and the continuation of historically low short-term rates represent a stimulative stance on balance, changes since the last Fed meeting seem to signal that the time for a less stimulative approach may be coming.

Changing conditions

The last time the Fed met, at the end of April, it had just been announced that economic growth had ground to a virtual halt in the first quarter (a subsequent GDP estimate revealed that the economy had actually shrunk). Also, inflation was running at a 1.5 percent year-over-year rate, below the Fed's target of 2.0 percent.

The context was a little different for this meeting. Four consecutive months of job growth in excess of 200,000 suggests that economic growth is back on track, and year-over-year inflation has risen to 2.1 percent. In fact, the recent trend of inflation numbers, with the past four months posting Consumer Price Index gains of 0.1 percent, 0.2 percent, 0.3 percent and 0.4 percent, respectively, seems to suggest inflation is building momentum.

All of this might influence the Fed toward a less stimulative policy, but it knows better than to overreact to a couple of months' worth of data. It will take more sustained evidence of growth and inflation before the Fed starts tapping on the brakes of monetary policy.

The other side of tapering

It should be noted that while the Fed has been steadily tapering back its bond purchases since the end of last year, the fact that it is still making any bond purchase represents an unusually stimulative monetary policy. Also, even when it reaches zero new bond purchases, that still won't represent a restrictive monetary policy -- that will start to come as the Fed begins to unwind the bond positions it has accumulated with these purchases in recent years.

In other words, tapering does not represent the reversal of this purchase policy -- that will come when the Fed becomes a net seller of bonds.

When that happens, it might finally signal the beginning of higher savings account rates, CD rates and money market rates. Banks have been able to accumulate deposits in recent years without having to offer very high rates, but as bond yields start to rise -- a likely outcome once the Fed starts selling bonds -- money is likely to leave the banks in search of more attractive yields unless banks raise rates to compete.

Again though, given the Fed's cautious approach to change, this scenario could take many months to play out. However, tapering represents the first steps toward this outcome -- even if they are baby steps.

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