The Fed Needs to Look to the Future

The FOMC statement released yesterday made it clear that, despite improvements in the economy, the Fed is not interested in raising rates or reabsorbing any of the liquidity out there. In fact, they "will continue to employ a wide range of tools to promote economic recovery and to preserve price stability."

I don't expect a change right now. Raising rates now or trying to get the Fed's balance sheet back to normal anytime soon would shock the system. Now is not the time. But we don't really read the Fed statement to read the committee's take on the current economic stituation. We are looking for some hints to the future. Apparently, the Fed is not looking far enough into the future to even hint in changes in policy. Alright, they "will gradually slow the pace of these purchases [mortgage-backed securities] in order to promote a smooth transition in markets," but this doesn't provide much guidance.
The main concern over rates is the impact on mortgage rates, and thus home purchases. If the Fed raises the target range for the federal funds rate from its current 0.0%-0.25%, the arguement goes, then mortgage rates go up and less people will buy homes. This is true, but not necessarily a bad thing. Many blame the whole housing bubble on Greenspan keeping rates low for so long, letting many people who shouldn't own homes get into them cheaply. Higher mortgage rates could slow recovery, but we face some risk in keeping rates low.

The real problem with low fed rate now, as I see it, is the effect on financial markets. With low rates, the yields that banks make on lending is also low. So, not only are banks reluctant to take on too much risk right now (for good reason), but they also don't have much financial incentive to do so. If the statement had hinted at the possiblity of raising rates even as soon as the first quarter of 2010 this would have gone a long way in getting money flowing again, inspiring banks to lend, helping businesses make the investments they should be making in this downturn.

I certainly agree with the inflation statement:
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.
When prices are dropping there is little need to raise rates to slow down anything. I would have liked, and it seems like the market would have liked, a stronger hint as to when and how the Fed will reign in all of its liquidity programs and begin to inch up interest rates. It also would have helped people to believe that a real recovery is taking place.