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FOMC Keeps It Steady Ahead

On September 21, the Federal Open Market Committee (FOMC) reaffirmed its commitment to keep the Federal Funds rate within the range 0 to 1/4 percent, as the economy continues with its fragile recovery. Though the National Bureau of Economic Research declared that the recession ended in June of 2009, the recovery has been hampered by pervasive unemployment and soft income growth. Moreover, as the Committee noted in its statement, underlying inflation is below the level it deems necessary, in the long term, to fulfill its mandate of maximum employment and price stability.

The market anticipated that the FOMC would maintain exceptionally low rates for an “extended period of time,” and these expectations are clearly reflected in Eurodollar futures. Eurodollar futures are forward rate agreements that allow market participants to speculate on or hedge against movements in short-term interest rates. In the case of Eurodollar futures, investors are betting on the risk associated with short-term changes in the Libor rate. The Libor rate is most associated with the cost of borrowing U.S. dollars for private, high-quality borrowers. By examining the Eurodollar forward rate curves, it is apparent that the FOMC’s policy decision did not dramatically impact the market’s expectations for interest rates going forward.

Eurodollar Forward Rate Curve

In addition to maintaining the federal funds rate at record lows, the Fed has sought to improve market function by purchasing longer-term securities. Since August 2007, total assets on the Federal Reserve’s balance sheet have expanded from $869 billion to nearly 2.3 trillion. The expansion in the Federal Reserve’s balance sheet is the result of purchases of agency debt, mortgage-backed securities (MBS), and longer-term treasuries.

Federal Reserve Balance Sheet

The Federal Reserve ceased purchasing agency securities at the end of the first quarter 2010. Additionally, as a result of lower mortgage interest rates, some of the principal of the MBS and agency securities held by the Federal Reserve had been repaid. As result, the level of agency and MBS debt on the Federal Reserve’s balance sheet has declined modestly. In order to maintain an accommodative monetary policy, the Fed plans to reinvest payments of principal on agency and MBS securities into longer-term treasuries. Even with principal repayments on MBS and new purchases of long-term treasuries, MBS still account for nearly 54 percent of Federal Reserve’s balance sheet.

Federal Reserve Balance Sheet

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