Wednesday, June 20, 2012

Fed Policy, June 20, 2012

The Fed announced an extension of Operation Twist, which will continue through the rest of 2012 (was supposed to expire this month).  For those not familiar with Operation Twist, it involves the Fed selling some of its holdings of short-term Treasuries coupled with an equal purchase of longer-term Treasuries (designed to reduce long-term interest rates, which more directly affect the interest rate on most loans).  How did financial markets respond?  A few minutes of volatility followed by little change in market interest rates.  Why?  Normally when the Fed eases policy, it purchases Treasuries, introducing more funds into the financial system (Treasuries are removed from circulation, cash enters the system).  With Operation Twist, it puts some in and takes some out, resulting in no change in funds in the system.  The main purpose is to try to reduce borrowing rates somewhat, though the effect is limited at best.

On a related note, the Fed released its new economic forecast.  It now expects even more modest economic growth and little change in the unemployment rate through the end of 2012 (ending the year between 8% and 8.2%; the current unemployment rate is 8.2%).  Inflation is expected to be less than its target (target is 2%, inflation is expected to be between 1.2 and 1.7% due to lower energy prices).  2013 is expected to continue to be a continuation of the modest recovery, with small declines in unemployment and low inflation.  In fact, unemployment is expected to remain above 7% through at least the end of 2014.

What about QE3?  The bar is set pretty high.  In order to implement a new round of quantitative easing, there needs to be a perception of possible deflation (as in 2008 (QE1) and 2010 (QE2)), recession (declining GDP/significant increases in unemployment), and/or financial contagion from Europe (financial markets freezing similar to 2008-2009).  A continuation of a modest recovery would only result in minor attempts at easing (reinvesting interest earned on its bond holdings, continuation of Operation Twist, etc.).  Other than preventing another collapse as in 2008, monetary policy can only have a limited effect on today's economy (given record low interest rates and banks holding over $1 trillion in excess reserves).