The Federal Open Market Committee will meet this week to set monetary policy. The financial markets see this meeting as a nonevent. The FOMC is widely expected to leave short-term interest rates unchanged and not alter its asset purchase plans. The wording of the economic assessment should be taken up a notch, which will give market participants something to react to – however, there’ll be no major shift in the Fed’s thinking. Looking ahead, the Fed will face a number of challenges this year, and not just on the economic front.

1. 6363 Woodway Dr
Suite 870
Houston, TX 77057
Phone: 713-244-3030
Fax: 713-513-5669
Securities are offered through
RAYMOND JAMES
FINANCIAL SERVICES, INC.
Member FINRA / SIPC
Green Financial Group
An Independent Firm
Weekly Commentary by Dr. Scott Brown
Fed Policy Outlook: Waiting It Out
January 24 – January 28, 2011
The Federal Open Market Committee will meet this week to set monetary policy. The financial markets
see this meeting as a nonevent. The FOMC is widely expected to leave short-term interest rates unchanged
and not alter its asset purchase plans. The wording of the economic assessment should be taken up a
notch, which will give market participants something to react to – however, there’ll be no major shift in
the Fed’s thinking. Looking ahead, the Fed will face a number of challenges this year, and not just on the
economic front.
The economic outlook largely remains a good news/bad news story. The good news if that the recovery is
continuing, even gathering a little more steam. The bad news is that the pace of growth is insufficient to
push the unemployment rate down significantly. The Fed has a dual mandate: stable prices and maximum
sustainable employment. While these goals may be seen to be in conflict from time to time, Fed officials
(and most economists) believe that economic growth can be maximized over the long run by keeping
inflation low. By “price stability” the Fed does not mean an inflation rate of 0%. Rather, the Fed’s implicit
goal is an inflation rate of around 2%.

2. There are two main concepts in the inflation process: inflation expectations and the amount of slack in the
economy. Inflation expectations act as an anchor for inflation. A high level of slack will tend to put
downward pressure on inflation (conversely, a lack of slack is seen as putting upward pressure on
inflation). Core inflation drifted lower in the first half of 2010. As a consequence, inflation expectations
fell from the spring to the summer. Inflation was getting too low for comfort. This concern was part of
what led to the Fed’s decision to increase its asset purchases. Once the Fed began to talk about additional
asset purchases, inflation expectations started to rebound. At the same time, Chairman Bernanke signaled
that the Fed remains committed to keeping inflation low over the long term.
Last August, the Fed decided to reinvest principal payments from its mortgage portfolio into long-term
Treasuries (about $35 billion per month). In November, it announced that it would buy an additional
$600 billion through the end of 2Q11 (or about $75 billion per month). The Fed promised that it would
“regularly review the pace of its securities purchases and the overall size of the asset-purchase program in
light of incoming information and will adjust the program as needed to best foster maximum employment
and price stability.” However, there’s been no indication that officials will alter the program anytime soon.
Chicago Fed President Charles Evans, who voted on the FOMC this year, said that changes to the Fed’s
asset purchase plans would face “a pretty high hurdle.”
The FOMC is comprised of the six Fed governors and five of the 12 district bank presidents (the NY Fed
president always has a vote, the four others rotate each year). Kansas City Fed President Hoeing, the lone
dissenter in 2010, will rotate off. Two other hawks, Philadelphia Fed President Charles Plosser and Dallas
Fed President Richard Fisher, will rotate on. The change in the lineup should not alter the Fed’s direction.
The Fed faces more intense criticism from Congress this year. In November, Republican leaders sent
Bernanke a letter questioning the Fed’s asset purchase program. Part of fiscal and monetary policy is
instilling confidence. The amount of public criticism against the federal fiscal stimulus and the Fed’s asset
purchase program surprised policymakers and most economists – and ultimately was counterproductive.
Criticism is natural in tough economic times. Confidence is likely to rebound as the economy continues to
recovery. The change in leadership in the House means that Ron Paul (R-TX), one of the Fed’s more vocal
critics (and author of the book “End the Fed”), will chair the House Financial Services Subcommittee on
Domestic Monetary Policy. Paul will lead the semiannual monetary policy hearings, the first coming up in
mid-February. He will have no authority to change the Federal Reserve, but he will likely use his position
to further criticize the Fed’s policies.

3. To paraphrase Mark Twain, a tweet by Sarah Palin can travel halfway around the world while Mr.
Bernanke is putting on his socks. Politics should not be a part of monetary policy. The independence of
the central bank is critical. However, the Fed should be able to survive the onslaught. Chairman Bernanke
has increased the Fed’s communications with the public, appearing on 60 Minutes, giving speeches to
business groups and the general public, and writing an op-ed in theWashington Post. However,
explaining monetary policy isn’t easy (most Americans could not explain the difference between fiscal
policy and monetary policy). Better job growth will help restore confidence in the Fed, but that will take
some time.