Federal reserves outlook on economy

Joshua Zumbrun, 09.23.09, 03:25 PM EDT
With the economy on the mend, the Fed will wind down its strategy of printing new money to support the mortgage market.

WASHINGTON -- The Federal Reserve expressed confidence in the strength of the U.S. economy Wednesday. At the end of a two-day policy meeting, the central bank said "economic activity has picked up following its severe downturn," an upgrade from its last statement in August, when it said economic activity was "leveling out."

The Fed is feeling confident enough to announce the winding down of its largest interventions in the economy: It said Wednesday that its $1.45 trillion effort to support the mortgage market will be phased out to conclude in March 2010. (See "Ending The $1.45 Trillion Shopping Spree.") Its $300 billion program to purchase government debt will end, as previously announced, next month. As widely expected, the Fed said it would keep interest rates at their floor, 0% to 0.25%.

The Fed's programs to purchase government debt, mortgage-backed securities and the debt of government agencies like Fannie Mae ( FNM - news - people ) and Freddie Mac ( FRE - news - people ) were remarkable not only for their size--a combined $1.75 trillion intervention--but because they were funded by printing new money. Because the process takes place electronically, no printing presses were fired up in the literal sense, but rather, with the click of a button, the Federal Reserve was creating new money to use in swapping mortgage assets. It was a risky and unprecedented strategy; when implemented by other countries, it has even led to hyperinflation and the destruction of a currency (see "Fed Faces Its Zimbabwe Moment").

The Fed is not yet prepared to start reversing its extraordinary actions--trying to mop up the new money it created--but it is ready to announce that the virtual printing presses will be shut off. Keeping them running until March may be risky, but the Fed sees little imminent threat from inflation. "With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the committee expects that inflation will remain subdued for some time," the Fed statement says, only a slight alteration from its statement in August. "Resource slack" refers to the widespread unemployment making it hard for businesses to find consumers willing to swallow price increases.On the economy, the Fed remains cautious, repeating its language from previous statements that household spending "remains constrained by ongoing job losses, sluggish income growth, lower housing wealth and tight credit" and that "businesses are still cutting back on fixed investment and staffing," though this month the Fed added "though at a slower pace." The Fed repeated its belief that not only will inflation remain subdued, "economic activity is likely to remain weak for a time."

As for interest rates, the Fed continues to show no sign of raising rates from the 0% to 0.25% range. The Fed repeated its language from previous statements verbatim: "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."
With unemployment still at extraordinarily high levels, the Fed is not yet ready to declare victory. But it is preparing to stop the presses.