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Health & Fitness

David Joy: Making sense of the divisions within the Fed

There seems to be a curious divergence within the Federal Reserve regarding the appropriate trajectory of future monetary policy. There also seems to be a curious disconnect between investor hyper-sensitivity to Federal Reserve intentions and the apparent strength of the economy.

Investors understandably hang on every word from the Fed, as they try to divine what it will do next. The latest example of this was in response to last week's release of the minutes from the Fed's June meeting. There was a muted market response, as it seemed the Fed attempted to bend over backwards to create the impression of a balanced debate toward future policy intentions. The minutes seemed to suggest that the Federal Open Market Committee was divided, that there was as much sentiment in favor of tapering QE3 relatively soon as there was toward maintaining the current pace of stimulus indefinitely. It wasn't until later in the day, in response to comments made by Chairman Bernanke at an economic conference in Massachusetts alluding to the notion that the economy remained in need of significant monetary stimulus, that investors concluded the liquidity spigot would remain open.

If, as the chairman said, one could only conclude that the economy remains in need of meaningful support, why did the meeting minutes go to such lengths to create the impression that the FOMC was far more evenly split on this question? Was it simply to assuage the dissident voices? Was it, in effect, the chairman's way of acknowledging their views while also dismissing them? A case can be made that it is difficult to effectively convey the distinction between the somewhat shorter-term policy of quantitative easing and the longer-term policy of zero interest rates. It is also difficult to explain the distinction between concerns among some of the members related to the risks associated with quantitative easing and the question of whether or not the economy needs it, or even whether it is doing any good. That might explain the Tower of Babel impression that the minutes created. Perhaps the minutes were written in such a way as to show the collegial atmosphere that Professor Bernanke attempts to foster. Whatever the case, investors would be wise to keep in mind that the voice that counts is that of the chairman. His view is the one that dominates the policy discussion, and he believes continued aggressive stimulus is the appropriate policy. Investors apparently took that message to heart as stocks rallied sharply on Thursday on their way to a new closing high.

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There also seems to be a dissonance between all of the handwringing surrounding the Fed's intentions and the actual strength of the economy. First of all, the Fed itself is historically optimistic regarding the economy. Rarely has the actual result been as rosy as they have forecast. Chairman Bernanke has said repeatedly that policy is data dependent and that it will be altered in the event that the Fed's own forecast is realized. Few private economists expect that it will, and yet the consensus on Wall Street is that the tapering of QE will begin in September. Maybe it will, but it is unlikely it will because the economy is as strong as the Fed thinks it will be. The data simply doesn't support that conclusion. The economy is doing okay, but the so-called central tendency of the individual FOMC members' forecast anticipates GDP growth for 2013 is 2.3-2.6% and 3.0-3.5% for 2014. In contrast, the Survey of Professional Forecasters compiled by the Federal Reserve Bank of Philadelphia anticipates growth of 2.0% in 2013 and 2.8% in 2014. 

It would be nice to leave the Fed behind for a while, and focus exclusively on economic data and earnings. Unfortunately, that will not be possible. Chairman Bernanke is scheduled to appear before Congress on Wednesday and Thursday this week. And the next FOMC meeting is just two weeks hence. The good news is that these are opportunities to provide more clarity on the likely path of monetary policy. But judging from recent experience, expectations in this regard should be set rather low.

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