財經觀察 2330: FOMC preview and QE-2

FOMC preview and QE-2

After more than a month of non-stop QE-mania, the day of reckoning is almost here. Next Wednesday afternoon the Fed will release the statement for the upcoming two-day FOMC meeting. We expect that statement will announce an intention to purchase $500 billion of longer-dated Treasury securities over the next 6 months. In addition, we expect the statement will express a willingness   but not necessarily a bias   to further increase asset purchases if warranted by economic conditions. Enhancing the extended period language by tying it more closely to observable economic variables may be an option, but we don t think it s an option they will exercise at this meeting.

The rationale for looking for $500 billion is fairly simple: $500 billion in asset purchases might be the equivalent stimulus of about a 50 basis point fed funds rate cut (very roughly: according to Fed research, this amount of purchases would lower long rates by about 25 basis points, and an old rule of thumb holds that every 2 basis point cut in the funds rate leads to about a 1 basis point reduction in long rates), and given the way the Fed leadership has recently described the economic outlook, it sounds like they would cut the funds rate 50 basis points if they could. They can t, of course, because the funds rate is already very close to zero, but they can attempt to exert similar stimulus through Treasury purchases. We believe that for next week s meeting only Treasuries will be mentioned as an asset to be purchased and think the language will refer to  up to  $500 billion, consistent with previous Fed asset purchase announcements.

Risks to the $500 billion view are both to the upside and downside (not surprisingly). The case for more than $500 billion in purchases next week rests on the fact that many policy rules suggest the economy needs more than the equivalent of a 50 basis point cut in the funds rate. Arguing against this is the fact that the policy tool that Fed is operating with does not have a historical record with which to calibrate its effectiveness, and so they should proceed more slowly than otherwise. This thinking   sometimes referred to as the Brainard uncertainty principle   was noted by Bernanke in his most recent major policy address when he noted that the FOMC should proceed with some caution in deciding whether to engage in further purchases of longer-term securities.  The case for doing less than $500 billion is that it provides greater flexibility and so respects the Brainard principle even more. The case against doing less than $500 billion is two-fold. First, a number like $100 billion would provide little additional stimulus, at least according to the Fed s own calculations. Second, it would be a major disappointment to the markets. While generally we don’t think the Fed is the slave to the markets that some people believe, in this instance we feel the committee has been pleased with the movement in financial conditions over the last two months and wouldn’t want to overturn the apple cart with a half-hearted asset purchase announcement. Regardless of what size gets announced, we expect both the size and the duration to be variables that are announced and not left for the market to guess. Also regardless of size, we expect the monthly flow of purchases to be a little under $100 billion per month.

Perhaps more important than the size of the asset purchases announced at the November meeting will be the signal they send regarding the prospect for further asset purchases. It seems very likely that however the statement is worded it will signal an openness to further asset purchases if conditions warrant. The only question is how strongly worded that openness is. For example, the August statement referred to a readiness to  employ its policy tools as necessary whereas the September statement referred to a readiness to  provide additional accommodation if needed, essentially moving from a neutral bias to an easing bias. If our timeline above is roughly correct, then the next decision on expanding the balance sheet wouldn’t happen until the second quarter of 2011, perhaps too far removed in time for the committee to realistically have a bias on policy, even if many committee members recognize that more purchases may be necessary at some point. Wording that could express a willingness but not a bias to engage in further purchases might note that the committee will continue to monitor and adjust the size and composition of the balance sheet to attain the longer-term monetary policy objectives consistent with the Federal Reserve s dual mandate. Some such wording might not be a promise to do more, but by tying the balance sheet to the dual mandate it would allow the market to draw its own conclusions based on the fact that the employment and inflation outlook could still be quite challenging in 2Q11.

On a related point, we are often asked whether the phrase mandate-consistent inflation rate" will make it into the statement. More important, we think, is simply the word mandate.  The recent emphasis on the Fed s mandate has been a guiding principle behind QE2. If this word is used in discussing prospects for future asset purchases it could be taken as a sign that the committee recognizes the November announcement may not be the last step in the process of returning employment and inflation to acceptable levels.

There are a few other options that appear as longer shots for how the Fed communicates with the market next week. First, after Bernanke s Boston speech, there was some talk that future asset purchases could be tied to the Fed s distant inflation forecast returning to the mandate-consistent inflation rate. While reasonable, uncertainty regarding the transmission mechanism will likely prevent them from adopting such an approach, for fear of strait-jacketing policy when there are so many unknowns regarding asset purchases. Second, another option Bernanke discussed in Boston was enhancing the extended period language to link it more explicitly to observable economic variables, such as key levels of core PCE inflation. While we are favorably inclined to this policy option, we think adding this on to the QE decision may be too much to get the committee to agree to at one meeting, and we don t see much change to the extended period language occurring at the upcoming meeting.