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Fed statement sets table for possible action on economy in fall

By Neil Irwin
Washington Post Staff Writer
Tuesday, September 21, 2010; 11:38 PM

Federal Reserve policymakers Tuesday opened the door to new action to try to boost the economy. They just didn't step on in.

With economic growth sluggish, the jobless rate seemingly stuck near 10 percent and inflation well below the level the Fed aims for, officials of the central bank are "prepared to provide additional accommodation if needed" to support the recovery and get inflation higher, said a statement from the Fed's policymaking committee. But they stopped short of taking action Tuesday.

In practice, that "additional accommodation" would probably consist of buying vast quantities of bonds, an unconventional step to try to pump hundreds of billions of dollars into the economy. Such an action would support growth by lowering long-term interest rates, making it cheaper for Americans to take out a mortgage or for businesses to borrow money to expand.

In one of the idiosyncracies of monetary policymaking, merely suggesting that such an action has become more likely caused financial markets to react in a way that helps achieve the goal. The interest rate on 10-year Treasury bonds fell to 2.57 percent Tuesday from 2.7 percent, reflecting the expectation of future bond purchases; that lower rate should in turn make mortgages and other long-term loans cheaper immediately.

With its statement Tuesday, the Fed was not committing to pulling the trigger on such an action, known as "quantitative easing," at its next meeting, Nov. 2 and 3. But it was a clear signal that leaders are more inclined in that direction than they had seemed just a few weeks ago.

"You have an economy slowing down and inflation below where they feel comfortable," said John Silvia, chief economist at Wells Fargo. "My bet is in November or December they will engage in quantitative easing unless we see a real upside surprise on the economy."

The Fed's statement suggested that the downward move in inflation is a prime reason the central bank is shifting toward new action. Consumer prices rose only 1.2 percent over the year ended in August, according to data released Friday, and 0.9 percent when volatile food and energy are excluded.

"Measures of underlying inflation are currently at levels somewhat below those" that Fed policymakers view as consistent with their mandate from Congress to maintain stable prices, the statement said. Fed leaders aim for inflation to hover in the range of 1.5 to 2 percent.

A somewhat higher inflation rate could strengthen the economy. It would give businesses and consumers greater incentive to spend money, lest it become less valuable as time passes, and make debts easier to manage. And while Fed leaders have been dismissive of the idea that deflation - or a destructive, self-reinforcing trend of falling prices - could set in, new policy action would be aimed in part at preventing that risk from materializing.

Some Fed officials who are skeptical of the ability of new bond purchases to drive down the unemployment rate are more confident in the ability of those steps to boost inflation toward their 2 percent target.

The Fed leaders did not make major changes to their assessment of the economy in the latest statement, repeating an assertion from their August meeting that "the pace of recovery in output and employment has slowed in recent months." They seemed to be slightly more optimistic about the outlook for bank lending, though the outlook for business investment spending seems to have weakened.The Fed noted that "housing starts are at a depressed level," although earlier Tuesday the Commerce Department said housing starts rose 10.5 percent in August from the month before, rebounding a bit from recent lows.

Monetary policy operates with a lag, and Fed officials will be deciding what to do based in part on their expectations of how the economy will do in 2011.

Over the coming weeks, Fed officials will prepare new forecasts for the years ahead. If, as expected, they no longer foresee the unemployment rate coming down significantly in 2011, that would set the stage for new bond purchases to be announced at the November meeting.

There is sure to be dissent within the Fed system should the committee decide to resume asset purchases. Kansas City Fed President Thomas Hoenig has dissented at every meeting this year, including Tuesday's, because he "judged that the economy continues to recover at a moderate pace" and thus the Fed's policy of ultra-low interest rates is no longer warranted.

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