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).

QE3!

The Fed has just announced a new round of quantitative easing (QE3).  Specifically, the Fed announced that it will start buying $40 billion worth of mortgage-backed securities per month (conditional on the performance of the labor market) and continue Operation Twist for the remainder of the year (sell short-term securities, buy long-term securities, $45b/month).  Also, it indicated that it anticipates maintaining low interest rates through mid-2015.  The goal is to reduce long-term interest rates, particularly mortgage rates, with the hope of increasing borrowing and spending in general and providing support to the housing market in particular.

How did financial markets react?  I'm writing this at 12:45pm (15 minutes after the announcement).  The initial reaction is a 0.5% increase in stock prices as well as some increase in gold & silver.  However, oil and gas prices have not risen.  What about long-term interest rates?  Yields on ten-year Treasury bonds have risen significantly, from 1.72% prior to the announcement to 1.82% as of 12:50pm.  Why would the yield on Treasuries increase?  Some possible reasons include the fact that the Fed is going to purchases mortgage-backed securities instead of Treasuries and concerns about higher inflation.

Was it the right move?  Argument in favor of it includes the weakness of the economic recovery (economic growth below 2% in the first half of 2012 & unemployment above 8% accompanied by subpar job growth).  Also, inflation is running below 2% (the Fed's target).  The hope is that lower long-term interest rates will spur growth providing some support to the recovery.  That said, Ben Bernanke and other members of the Fed know and hae stated that there are limits to any benefits.

Arguments against include that this will probably have a very limited effect on economic growth.  Interest rates are already near historic lows.  Also, though overall inflation is below 2%, core inflation is close to 2%.  Energy prices are already rebounding from recent declines, so overall inflation will rise in the coming months (beginning with tomorrow's inflation report).  Also, as mentioned in a previous post, expected inflation as measured in the market for TIPS (treasury-inflation-protected securities) is not that low (break-even inflation over the next five years is about 2.1% and rising somewhat in recent weeks compared to significant declines prior to QE1 and QE2).  Also, this will complicate the Fed's exit strategy.

What's the take away?  Though the Fed has discussed the limits to another round of QE3, it chose to implement a new round of quantitative easing.  It did make it contingent on the performance of the economy, so if the economy strengthens, it could choose to stop QE3 after a few months.  More likely, it will continue well into 2013.  Also, it can't be accused of trying to finance the budget deficit since it chose to purchases mortgage-backed securities instead of government bonds.  What's my initial take?  I would have voted no.  I don't anticipate significant benefits and I think it introduces more distortions to financial markets that may be hard to unwind.  Do I think it will lead to rapid inflation?  Not anytime soon.  I wouldn't be surprised if there are more posts on this topics in the coming days.