Fed announcement: 12-12-12

The Fed broke more new ground today in it's policy announcement.  As expected, with the end of Operation Twist (selling short-term securities and buying long-term securities), it now plans to purchase long-term Treasuries ($45 billion per month) in addition to $40 billion worth of mortgage-backed securities each month.  If you do the math, that's about $1 trillion per year (for comparison purposes, net purchases were $2 trillion over the past 4 years).  How long will continue with such a loose monetary policy?  Rather than saying until things get better, the Fed got specific.  To quote:

"the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored."

Ben Bernanke will discuss this at his news conference this afternoon, but here's what they're thinking.  Inflation is low and is expected to remain low for quite a while.  The Fed is comfortable as long as inflation stays close to its medium-term target of 2%.  Specifically, high inflation is now defined as a medium-term forecast exceeding 2.5% (medium term means 1 to 2 years from now).  In addition, inflation expectations need to be contained (not sure what their gauge will be, but possibly based on the TIPS market).  Assuming that inflation is under control, the Fed will keep the federal funds rate between 0-0.25% as long as the unemployment rate is above 6.5%.  Why 6.5%?  The Fed considers NAIRU to be between 5.2% and 6%.  What does that mean?  The Fed thinks unemployment would have to fall below NAIRU for there to be upward pressure on inflation; 6.5% gives it a cushion given that monetary policy takes some time to have an effect (and takes some time to reverse those effects). 

Key points:

• So rather than stating that interest rates will remain low until the economy improves or as long as inflation is contained, the Fed has now stated what that means.  Recall that the Fed has a dual mandate - low inflation and low unemployment.  It now has stated specifically how achieving both parts of that mandate will guide their policy in the coming years.
• It should be noted that the Fed statement says the federal funds rate will remain low as long as unemployment is above 6.5% and expected inflation is less than 2.5%.  That doesn't necessarily mean that it will engage in quantitative easing (bond purchases) for that same period.
• When is unemployment is expected to decline to below 6.5%.  Based on the December Fed forecast, this will take place in 2015, while most private forecasters think that won't occur until late 2015 or 2016 (see my economic forecast page).