At next week’s Fomc meeting (the first one after the end of QE2), the Fomc should confess that QE2 has not worked as planned and admit that a different strategy is needed to stimulate the economy via lower bond yields.  Bond yields are currently nearing historic lows because market participants are worried about a double-dip recession – the very opposite of what the Fed wants to achieve.  My suggestion is that their next statement should read along the following lines :

Release Date: August 9, 2011

Information received since the Federal Open Market Committee met in June confirms that the economic recovery is continuing, though at a disappointingly slow rate that has been insufficient to bring about a significant improvement in labor market conditions. Households remain under the cosh because of high unemployment, no pay rises, falling house prices, and the high cost of borrowing money. Businesses are doing OK but they don’t need to buy new equipment because they still have lots of spare capacity (and they are not hiring either for the same reason).  High commodity prices are not exactly helping with gasoline still near $4/gallon.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The unemployment rate has been stuck above 9% for 18 months now and refuses to come down, despite us having purchased $2.9 trillion of bonds.   Both QE programs have failed to stimulate the economy into creating enough jobs to bring the unemployment rate down. Although the Committee is praying for a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to try a different approach.  Namely not to buy any more bonds but instead to encourage a lower yield curve across the bond market via a promise to keep the Fed Funds rate near zero until the unemployment rate nears 6%.  In so doing the Committee anticipates that a steep yield curve will be exploited by market participants playing the carry trade, withdrawing money held at the Fed and spending it (with additional leverage) on buying Treasury bonds. In particular, the Committee is keen to make it crystal clear to all market participants that the Fed Funds rate will stay at 0 to 1/4 percent until Chairman Bernanke makes a speech saying otherwise (don’t hold your breath waiting for that speech).  Committee members will regularly and publicly repeat this 0 to 1/4 percent guidance every time market participants worry that interest rates are to be tightened in the near future.

The Committee will maintain the target range for the Federal Funds rate at 0 to 1/4 percent until Chairman Bernanke hints otherwise, and certainly for far longer than overpaid Wall St economists currently believe.

The Committee will continue to monitor the economic outlook and financial developments and will only start to think about tightening policy once the unemployment rate nears 6%, or if inflation goes up before then.

For the avoidance of doubt and given that purchasing $2.9 trillion of bonds has failed to bring down the unemployment rate significantly, the Fed will in future no longer reinvest principal repayments and will from now on allow its balance sheet to shrink as its existing inventory of bonds mature.

The entire Committee voted unanimously for the above FOMC monetary policy action.

Post-Script : 10 Aug 2011.  Yesterday the FOMC announced they would be keeping the Fed Funds rate near zero for the next two years (“at least through mid-2013“).  However they chose to keep reinvesting principal payments from their $2.9 trillion inventory of bonds.