The equity markets were looking for “accommodative” language coming from the FOMC and they definitely got it.  The Federal Reserve stated that they will reinvest principal payments on their current MBS holdings into longer dated treasury securities.  This is generally considered an extension of the Fed’s “quantitative easing”.  If you do not understand quantitative easing please refer to my previous article “Quantitative Easing and Walking on the Edge of a Razor“.  If you still do not understand, don’t feel badly because it doesn’t make any sense.  The federal reserve basically funds the Treasury.  One arm of the government feeds the other arm and we suddenly have a perpetual motion machine.  The premise is that by buying securities, the Federal Reserve creates demand on the longer part of the interest rate curve which lowers rates for all of the debtors that need to raise debt.  But hold on, the government is buying its own debt….  That’s like you purchasing your own mortgage note.  The difference is that the federal reserve prints its own money, so they are able to purchase their securities with money out of thin air.  That money permeates the financial system because dollars end up in investors hands as the treasuries or MBS securities that the investors were holding were purchased by the Federal Reserve in exchange for dollars.  The Fed effectively puts more liquidity into the financial system.

Still, it doesn’t make any sense.  By printing money to buy its own debt, the government should effectively be creating inflation with the increased dollars in the system.  The threat of inflation should increase the nominal yields of the bonds that they are purchasing and thereby negate what they set out to do in the first place, which was to decrease interest rates.  All hand waving aside, it does seem to work for a short period of time and it most likely has to do with the signal that this action provides for the financial markets.  It says loud and clear that, “I, Ben Bernanke, will do whatever is in my physical power to keep this system afloat!”  Our boy Ben even literally made this statement when he said that the Fed was “prepared to take further policy actions as needed” to support an economy hobbled by 9.5% unemployment.   This means that the reinvestment of principal payments back into treasuries is only a first step and that if the economy sputters we could see the Federal Reserve ignite the system with trillions of dollars as needed because deflation is currently our public enemy number one.

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 utilization 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 Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.1 The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature.

The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.

Voting against the policy was Thomas M. Hoenig, who judges that the economy is recovering modestly, as projected. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and limits the Committee’s ability to adjust policy when needed. In addition, given economic and financial conditions, Mr. Hoenig did not believe that keeping constant the size of the Federal Reserve’s holdings of longer-term securities at their current level was required to support a return to the Committee’s policy objectives.