Key points
- Slow economic growth, high unemployment and the prospect of tighter fiscal policy next year will most likely mean the Fed will likely keep its unconventional monetary policies of low interest rates and bond buying intact in 2013 and beyond.
- The FOMC recently moved to tie its policy to explicit targets for unemployment and inflation rates. At the current pace of economic growth, following these targets implies that short-term rates could remain near zero for at least two years.
- The annual rotation of FOMC voting members isn't likely to alter policy, in our view, as the majority of voting members' views appear to align with current policy.
- As Ben Bernanke approaches the last year of his term as Fed chairman, we believe he'll provide a blueprint for an exit strategy from the current unprecedented policies used by the Fed during his tenure.
The unconventional becomes conventional
The Federal Reserve adopted its "unconventional" approach to monetary policy more than four years ago in response to the financial crisis and subsequent recession. In late 2008, it extended special loans to banks and lowered the short-term fed funds target rate to zero. Subsequently, the Fed undertook two bond-buying programs—Quantitative Easing 1 and 2—to expand its balance sheet to an all-time high of $2.86 trillion, compared to $986 billion in June 2007.
Later in 2011 the Fed extended the maturities of its bond holdings by swapping short-term bonds for long-term bonds in "Operation Twist," and in September of this year, a program of open-ended bond buying, including mortgage-backed securities (MBS), was announced and dubbed QE3.
Ten-year Treasury Bond Yields and Fed Easing Programs: 2000-2012
Source: St. Louis Federal Reserve. 10-Year Treasury Constant Maturity Rate (GS10), Percent, Monthly, Not Seasonally Adjusted.
Under Fed Chairman Ben Bernanke, the Fed has gone to new lengths to increase the transparency of its decision-making process, with post-meeting press conferences and publication of its forecasts for the economy, employment and inflation. Openness about its policy-setting process and outlook is seen as a "signaling" tool, a means of providing a long-term outlook to market participants. The reasoning is that if the market believes that the Fed intends to hold interest rates down over a long period of time, investors will act on expectations of low interest rates by refinancing existing debt, increasing spending and investment, resulting in a stronger economy.
Despite all of these unconventional efforts on the part of the Fed, the economy's pace of economic expansion is still "frustratingly slow" in the words of Bernanke. The recovery, which officially began in the second quarter of 2009, has been weak compared to most post-WWII expansions. Gross domestic product (GDP) growth has averaged only 2.6% annually since the recession ended, making it the weakest recovery in post-war history. Job growth has been sluggish as well, with unemployment still high at 7.7% compared to 5.0% in December of 2007.
Economic Indicators: Real GDP
Source: Federal Reserve Bank of St. Louis using real gross domestic product, 3 decimal (GDPC96), Index 2009:Q2=100, quarterly, seasonally adjusted annual rate, month zero=June 2009, data as of December 7, 2012.
Looking into 2013, the Fed has made it clear that it will continue its expansive monetary policies. In addition to slow growth and high unemployment, the economy is facing headwinds from the prospect of tighter fiscal policy and recession in Europe. While it's often been noted that the Fed's policies have had diminishing effects over the past few years, we doubt that will deter the Fed from continuing down its current policy path.
After all, it's reasonable that the biggest impact would have been felt when the economy was weakest and financial markets their most fragile. Comments from Bernanke and other officials have made it clear that they see the economic benefits, in terms of bringing down unemployment and supporting the housing recovery and other asset markets, as outweighing the risks.
In the near term, the Fed has announced it will extend its Treasury bond buying into next year, purchasing up to $45 billion per month. Currently, Operation Twist—the program where the Fed has been selling short-term Treasury bills and notes and buying long-term Treasury bonds—is scheduled to end December 31, 2012. The program, which did not cause the balance sheet to expand, was supplemented in September with additional purchases of as much as $40 billion per month in MBS purchases.
The result of continued bond buying is likely to be a rapid expansion of Fed holdings over the course of the next year, bringing the total to close to $4 trillion. If the Fed didn't extend its bond purchases, then the duration of its portfolio would begin to decline as the time to maturity of its portfolio would shorten, with the possible effect of allowing interest rates to rise.
Adopting Evans Rule could mean lower for a lot longer
With the adoption of the "Evans Rule," Fed policy is conditional on hitting explicit levels of unemployment and inflation. The rule—named after a proposal by Federal Reserve Bank of Chicago President Charles Evans—says that the Fed will continue its easing policies until unemployment reaches 6.5% and inflation remains below 2.5%. Fed officials have previously indicated that the 5.2% to 6% range is considered full employment and 2% or less is considered price stability, but it appears that by setting these targets, they've opted to give themselves some room for error and take into account the lag between policy action and results.
Previously, the Fed had issued time frames that it expects its current policies to remain intact. As of the last Fed meeting in October, the Fed indicated that its zero-interest-rate policy would most likely remain until mid-2015. The Evans Rule replaces this date-targeting approach.
Nonetheless, investors are still going to be trying to figure out how long it will take to reach these targets. Currently, the unemployment rate stands at 7.7% and the annualized inflation rate at 1.6%, as measured by the deflator for personal consumption expenditures, the Fed's preferred inflation reading. These are levels believed to be sustainable and optimal for the economy, according to the Fed.
FOMC Economic Projections 2012-2015
Source: Federal Reserve Bank of St. Louis, as of December 10, 2012. Note: Projections are the midpoints of the central tendencies. The unemployment rate is the average for the fourth quarter of the year indicated.
Based on the current unemployment rate and pace of job growth, we estimate that it could take two to three years to reach the 6.5% level. Year-to-date through November, the average increase in jobs per month has been 154,000 (as measured by nonfarm payrolls). At that rate, it would take until late 2015 to reach the 6.5% unemployment level, assuming the current rate of growth and participation rate in the labor force.
Recently, there have been substantial numbers of people dropping out of the labor force, which has reduced the participation rate (the percentage of people in the labor force) from 66% in 2007 to its most recent reading of 63.6%. This phenomenon is usually associated with weak economies. People often become discouraged and give up looking for work when the economy is growing at a slow pace.
In fact, in the November report, the number of discouraged workers was reported at 979,000. If the economy improves, it's likely some of these people will begin looking for work again, causing the participation rate to rise, which could slow the decline in the unemployment rate.
But it's also likely that the aging of the overall US population has contributed to the decline as the baby boom generation moves into retirement. Since retirement ages vary by individual, it's difficult to estimate just how great an impact this trend is having on the unemployment rate, particularly since there have generally been net job gains among older workers as compared to losses among younger workers over the past few years.
Nonetheless, the combination of these two factors—discouraged workers and demographic trends—suggests that job growth may not need to rise to levels seen in previous expansions in order to reduce the unemployment rate. If monthly payroll growth picks up to 175,000 per month, then the unemployment rate could reach 6.5% by late 2014. On the other hand, if the participation rate continues to fall and levels off at 63%, then the Fed's target could be achieved in two years even without an increase in payroll growth. The bottom line is that the adoption of the Evans Rule would still suggest that the "lower for longer" policy will most likely remain intact in 2013 and beyond.
Full Employment—Long Way to Go, Short Time to Get There
Source: Federal Reserve Bank of Atlanta, as of December 17, 2012. Numbers are estimates, assume a constant labor force participation rate of 63.6%, assume a constant average population growth rate of 0.0772% and show the average monthly change in payroll employment. Assumes 12-, 24-, 36- and 48-month periods. Hypothetical example for illustrative purposes only.
What would happen if inflation rose above the Fed's 2.5% target before the unemployment rate fell to 6.5%? Would the Fed choose inflation over unemployment? This was a question posed to Bernanke in the press conference following the December meeting. His answer was that the Fed would remain vigilant on inflation, and by setting the unemployment rate target at 6.5%, a level it views as above full employment, the Fed has leeway to alter policy before inflation pressures increase.
Annual rotation—likely a nonevent
Every year, four of the 12 voting members on the Federal Reserve Open Market Committee (FOMC) rotate. There are seven governors of the Federal Reserve and 12 district bank presidents. The seven governors are permanent voting members, along with the president of the New York Fed. That leaves four votes that rotate annually among the remaining 11 district presidents.
In 2013, one district bank president who's been a steady dissenter to the accommodative monetary policy actions, Jeffrey Lacker of Richmond, will be rotating out. Among the incoming district-bank presidents, there are two known for holding more-dovish views, the aforementioned Charles Evans and Eric Rosengren of Boston. The other two, Esther George of Kansas City and James Bullard of St. Louis, have voiced concerns about the Fed's policies in their public comments. However, voicing concerns about Fed policies does not always lead to a dissenting vote. We don't see the likelihood of a major shift in policy based on the annual rotation of voting members.
Exit strategy—communication will be key
Based on our expectation that the Fed will maintain a longer-term policy of keeping interest rates low in 2013 and beyond, it may seem premature to discuss its exit strategy. However, Bernanke's current term as chairman will end January 31, 2014, and there have been indications that he may not seek re-nomination when his term ends. Since Bernanke is widely viewed as the architect of the current extraordinary and unconventional policies, we expect that he may want to lay the groundwork for an exit from these policies before he leaves office.
In June 2011, the Fed laid out a blueprint for its withdrawal strategy from quantitative easing. At the time, the plan indicated that in mid-2015 the central bank would begin to reduce its balance sheet to pre-financial crisis levels over the course of two to three years. However, the more the balance sheet expands, the harder it is to wind down. Selling off bonds too quickly could cause interest rates to spike and send the economy back into recession, while moving too slowly could mean higher inflation as a result of too much money circulating in the economy. Just the expectation of a policy shift could send inflation expectations and interest rates higher.
A passive strategy of allowing bonds to mature and "roll off" the balance sheet would not result in much decline in the near term, since Operation Twist extended the maturities of bonds in the portfolio. Based on the latest data, there will only be $470 billion of Treasury and agency bonds maturing between now and 2017. While that's a high number in absolute terms, it's not that large in light of the Fed's $2.86 trillion in holdings. Estimates of when bonds will mature have been complicated by the Fed's purchases of MBS since the maturity of these bonds can extend or shorten depending on how rapidly the securitized mortgages are repaid.
Fed Balance Sheet by Maturity (in Millions)
Source: Federal Reserve, as of December 6, 2012.
One possibility is that the Fed would execute a swap with the Treasury of long-term bonds for short-term bills and notes to reduce the average maturity of its portfolio and speed the roll off of its balance sheet. This would be unconventional and unprecedented, but within the realm of possibility in our view. In addition, the Fed can drain reserves from the system with its more conventional tools, such as repurchase operations and adjusting the interest rate it pays on bank reserves.
Bottom line
The Fed's "lower for longer" policy appears likely to remain intact in 2013 and beyond. Until there are clear signs of stronger growth and/or inflation pressures, the Fed appears poised to maintain and even expand its current bond-buying programs. Consequently, we expect to see short- and long-term interest rates remain low next year.
As we see it there will be two major legacies of the Bernanke Fed—unprecedented expansion of monetary policy and unprecedented transparency. As his term winds down next year, we expect that he and the other members of the FOMC would try to communicate a clear blueprint for exiting its current policies. Managing expectations will be as important as managing the balance sheet, in our view.
