by Don Alexander, MBA
Associate, RSD Solutions Inc.
Recent US Economic Developments
S & P has downgraded the US long-term sovereign debt rating from AAA to AA+ and kept the rating outlook as negative. They noted a further improvement in the fiscal situation will be required to avoid further downgrades (reducing the deficit by $4tr not $2tr). Moody’s & Fitch have not altered their AAA rating at the current time. The US short-term rating remains intact at A1+, with no impact expected on money market funds.
US non-farm payrolls showed gains of a little over 115,000 with unemployment rate at 9.1%. The gains in the private sector were partially offset by a decline in government employment. The US economic growth was revised lower to 0.8% in the first half of the year. Overall, a number of investment firms have lowered growth estimates through 2012 year-end to a little over 2%.
Conventional Fed Policy Options
Fed officials enter August with weaker than expected economic growth and projections of extended period of below trend growth increasing the pressure for further monetary easing. This has a similar parallel to last year and if further downside risks persist, the Fed may implement QE III. Currently, the Fed’s three conventional policy options: communication to investors & the public, asset purchases & sales and interest rate policy.
The first option the Fed might consider is “forward guidance” given the size of the Fed’s balance sheet. This might have a minimal economic impact, but could be combined with a link to a specified period of low policy rates or an economic event. Asset purchases or sales are a second policy option, but are limited by the size of the Fed’s balance sheet. One application is to keep the balance sheet size the same, but to increase the duration risk by buying longer-term securities. This could be combined with a reinvestment of maturing mortgage holdings. Any proposed increase in the aggregate duration risk would be considered as policy easing. The last option is to cut the interest paid on excess reserves left at the Fed. This would have minimal impact since effective fed funds are already 0.08% and a zero rate on excess reserves could damage market institutions.
Fed action would only be driven by increased downside risk. Any change in communication or composition of the balance sheet would have at best a symbolic impact on the economy. The US economy stands on the risk of falling into a double-dip recession; the Fed clearly lacks conventional policy tools to do much about it unless combined with other policy alternatives.
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