Fed downgrades growth to stir deflationary fears

The US Federal Reserve last night significantly downgraded its expectations for the US economic recovery and made a major, if largely symbolic, move towards more monetary easing

The Bank said that the existing monetary stimulus which is maturing will be re-invested into longer-dated US Treasury bonds. This will represent an annual re-investment of around $150 billion out of agency debt and mortgage-backed securities and into treasuries. The move sent yields on five and ten year US government debt to historic lows.

It marks the Bank's first serious step towards the deflationary camp and was accompanied by an assurance that its base rate would stay low for a prolonged period of time.

The market had expected action after a slew of bad data including dire jobs news since the last meeting of the Reserve's board of governors.

In its statement the board said: 'Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.

'Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Bank lending has continued to contract. Nonetheless, the committee anticipates a gradual return to higher levels of resource utilisation in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.

'Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.'

The move was supported by all but one of the committee members with Thomas Hoenig arguing that it was time to tighten.

US markets, which had been slipping badly on fears the Fed would not move, rallied on the news. The Dow Jones Industrial Average had been down 147 points but closed just 53 points lower, a loss of 0.5%.

While the move will be viewed by ardent deflationists as evidence to support thier vies Mark Ostwald of Moument Securities warned them to take note of the committee's moderated tone on that score.

He said: 'For the deflationists out there, please take note of the following sentence: "Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time." This is at worst low or dis-inflation, and not deflation, and we would refer again to the lack of any deflation talk in Bernanke's recent semi-annual testimony.'