Federal Reserve policymakers took the unusual, though not entirely
unexpected, step of signalling their concern about the outlook for
economic growth, employment and price stability at their customarily
tranquil August meeting. The Federal Open Market Committee went beyond
merely reviewing its options for providing additional support to the
economy, as Chairman Ben Bernanke had hinted it would in late July
Congressional testimony, and actually implemented significant new
measures in a bold, albeit, risky move which was taken by some as an
unnecessary signal of alarm about the outlook.

Until relatively recently, most of the talk had been about when the
FOMC might begin shrinking the Fed’s balance sheet and raising interest
rates. That was the main thrust of Bernanke’s comments as recently as
his July 21-22 Congressional testimonhy. He talked about the FOMC
evaluating possible new quantitative easing measures, but seemed to set
a fairly high bar for actually doing so. He spoke of such steps being
activated should the economy “worsen appreciably” or “falter.” He gave
no clear, new signals about his views in an Aug. 2 speech, beyond saying
that “we have a considerable way to go to achieve a full recovery.”

So, while it was not unanticipated, the FOMC’s announcement that it
would prevent shrinkage of the Fed’s balance sheet (and bank reserves)
raised a few eyebrows. The market reaction was less than uniformly
positive.

True, there had been some discouraging indicators, including the
second quarter slowdown in GDP growth and the decline in June-July
non-farm payrolls, but many Fed watchers questioned whether that
warranted a policy shift. And so did Kansas City Fed President Thomas
Hoenig.

After observing that “the pace of recovery in output and employment
has slowed in recent months” and after repeating its usual concerns
about the usual restraints on household spending, the Fed declared, “To
help support the economic recovery in a context of price stability, the
Committee will keep constant the Federal Reserve’s holdings of
securities at their current level by reinvesting principal payments from
agency debt and agency mortgage-backed securities in longer-term
Treasury securities.”

The Fed said it “will continue to roll over the Federal Reserve’s
holdings of Treasury securities as they mature,” but by reinvesting the
proceeds of MBS in Treasuries, the New York Fed announced it “will seek
to maintain the value of outright holdings of domestic securities at
around $2.054 trillion.”

The significance of the FOMC’s activist policy is two-fold:

1. Reinvesting proceeds of maturing MBS and agenncy debt in 2-10
year Treasury securities will prevent what would otherwise have been a
shrinkage of the balance sheet by $200 billion or more by the end of
2011, according to New York Fed estimates.

2. More importantly, the FOMC is telling the world that, beyond the
usual “extended period” of “exceptionally low” short-term interest
rates, it is prepared to maintain an even more assertively accomodative
monetary policy for as far as the eye can see.

The Fed is tacitly saying that it is concerned not just about the
strength of the recovery but about the ability of the U.S. economy to
avoid a Japan-style deflation. Some may think it alarmist — even
unjustified if you’re Kansas City Fed President Thomas Hoenig. But that,
for better or worse, is where the U.S. central bank is, as it lets its
remaining ammunition against a real negative shock dwindle.

[TOPICS: M$$BR$,MMUFE$]