It seems like every market participant around the world has at least one eye on the meeting of the Federal Reserve Open Market Committee this week, and for good reason. The FOMC is the arm of the U.S. Federal Reserve responsible for open market operations — i.e. quantitative easing — and it will conclude a two-day meeting on Wednesday. After the meeting, Chairman Ben Bernanke will hold a press conference and answer some questions.
Not to be dramatic about it, but what Bernanke says at the conference will help set the tone of the global economy. Recent history has shown that speculation over tapering of purchases can cause market volatility. Record-low interest rates — driven downward by the near-zero benchmark and QE itself — has proved to be a boon for equities and businesses looking to borrow money to invest in new capital. Remove fuel from the machine, and the markets will have as wild time adjusting.
Broadly speaking, the Fed engages in open-market operations in order to try to keep the federal funds rate — the interest rate at which banks lend reserve balances to each other overnight — near its target. The Fed lowered its target federal funds rate to near zero (between 0.00 and 0.25 percent) on December 16, 2008, and has held it there ever since.
Under more normal economic circumstances — that is, not in the wake of a major global financial crisis — the Fed would pursue the target federal funds rate by manipulating the discount rate (interest charged to commercial banks and depository institutions on loans they receive from the Fed) and reserve requirements. These can appropriately be thought of as tools, and they are stewarded by the Board of Governors of the Federal Reserve System.
But in a near-zero rate environment, these tools pretty much lose their effectiveness. This is where the FOMC steps in with open-market operations and unconventional policy, or “alternative tools,” such as forward guidance and QE — the large-scale purchase of longer-term Treasury securities (currently $45 billion per month) and agency mortgage-backed securities (currently $40 billion per month).
Like its traditional tools, QE is intended to put downward pressure on real interest rates. In general, a low-interest rate environment will help stimulate economic activity, which has been the goal of the Fed in the post-crisis era. Markets and businesses have adapted to — or become addicted to — this new environment.
QE was never meant to last forever. The goal has always been to provide a short-term boost while underlying conditions had time to improve. In the wake of the collapse of the housing and credit bubbles, this meant millions of people losing their jobs, dealing with underwater mortgages, and watching the value of their equity holdings evaporate.
In his testimony before Congress, Bernanke stated that “In the current economic environment, monetary policy is providing significant benefits. Low real interest rates have helped support spending on durable goods, such as automobiles, and also contributed significantly to the recovery in housing sales, construction, and prices.”
“Higher prices of houses and other assets, in turn, have increased household wealth and consumer confidence, spurring consumer spending and contributing to gains in production and employment. Importantly, accommodative monetary policy has also helped to offset incipient deflationary pressures and kept inflation from falling even further below the Committee’s 2 percent longer-run objective,” he continued.
In other words, the ball is rolling. It may not be rolling fast enough, but what movement there is can be in large part attributed to accomodative monetary policy. With all this said, it’s clear why market participants are tuned into the FOMC meeting. A change in Fed policy is arguably the biggest catalyst that could hit the market right now.
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